Shedding Light on China’s Massive Shadow Banking Market – Regulations: For Better or For Worse…? – Part 2

Introduction

The debt level of the PRC¹ is rising. It is estimated that the PRC’s corporate debt could hit US$13.8 trillion in 2014, surpassing that of the United States as the largest in the world. This has raised increasing concerns in the non-bank financial market, particularly the shadow banking market, upon which the huge growth of debt in the Chinese economy is largely centered. Shadow banking is a term for the collection of non-bank financial activities that provide services similar to conventional commercial banks, sometimes through the conventional commercial banks. In general, shadow banking takes place through three types of institutions². The first includes third-party wealth management products and trust companies, or financial institutions without licenses and regulatory oversight. The second category is credit guarantee companies, microcredit firms, or those without licenses and partially regulated. The last type includes entities with licenses but with inadequate regulation, such as money market funds, securitized products, and off-balance sheet products.

On March 7, 2014, the first onshore³ bond default occurred in Mainland China⁴. The default concerned an onshore corporate bond issued by a struggling Chinese solar-equipment manufacturing company and was not a product of the shadow banking market. However, the alarm this event triggered is by no means confined to the non-bank corporate bond market, and it has forced reflection upon the threat that the non-bank financial market as a whole, particularly the shadow banking market, in the PRC is posing. While the State Council of the PRC (“State Council”) recognized that the emergence of shadow banking is an inevitable result of financial development and innovation, and that it plays a positive role in serving the real economy and diversifying investment channels as a complement to the traditional banking system, it became clear to those in charge that shadow banking must be put under oversight and supervision. Indeed, the virtues came with vices, and shadow banking had in recent years become one of the main causes of headache in the financial market.

While regulations are designed to solve issues, they may create problems of their own. On the one hand, regulations should be thoroughly considered in terms of their repercussions on the market; on the other, regulators may find it difficult to catch up with the evolving concept of shadow banking. Part of the answer lies in macro-prudential regulations, the role of which is to identify risk concentrations, common exposures, linkages and interdependencies that are sources of contagion and spillover risks, giving rise to systemic concerns. These in turn call for adjustments in micro-prudential supervision. Examples can be found in countries such as Spain and Portugal.

This eUpdate is part 2 in a series of eUpdates on this topic. Part 1 explores and reflects upon the circumstances pertaining to the landmark default in March 2014, the change it marked and the alarm it triggered for Mainland China’s non-bank financial market. Part 2 discusses efforts made and issues related to regulating the shadow banking market.

Strength of Regulations (or the Lack of It)

The People’s Bank of China (“PBOC”) has recently ratcheted up efforts to crackdown on the shadow banking market⁵. The State Council Document No. 107 in December 2013 called for the strengthening of shadow banking regulation⁶. The PBOC and the National Audit Office also announced in January 2014 that they would begin an audit of shadow banking. The China Insurance Regulatory Commission (“CIRC”) has also issued an internal notice warning of risks involving so-called insurance investment programs, off-balance sheet debt schemes issued by asset management and insurance firms to raise money from insurers and other institutional investors to invest in industrial projects⁷.

Duties are divided among various organizations of the Central Government:

• All financial institutions’ wealth management business will be regulated by the State Council;
• Banks’ wealth management business will be regulated by the China Banking Regulatory Commission (“CBRC”);
• Securities and futures organizations’ wealth management business and private equity funds will be regulated by China Securities Regulatory Commission;
• Insurance organizations’ wealth management business will be regulated by the CIRC;
• Financial institutions’ cross-market wealth management business, and third party payment business, will be regulated by the PBOC;
• Businesses already specified with regulators should be regulated by the specified regulators in the Central Government and local governments;
• Financing guarantee companies will be regulated by the rules set by financing guarantee business inter-ministerial joint conference, led by the CBRC. Local governments are responsible for the implementation of the detailed regulations; and
• Microfinance companies will be regulated by rules set by the CBRC and PBOC. Provincial governments are responsible for the implementation of the detailed regulations.

The rapid growth of shadow banking we have seen over the past years stemmed from the introduction of monetary tightening policies imposed on conventional banks. The existence of shadow banking was for regulatory arbitrage. Wealth management products, as an illustration, evolved out of conventional banks’ balance sheets.

As is always the case, the strength of the regulation will come down to the strength of its detail and implementation. Document No. 107 was issued to all provincial, autonomous regional and direct-controlled municipal governments; all ministries and commissions of the State Council, as well as subordinate departments for all regions and departments concerned to formulate detailed implementation plans to ensure that all measures are effectively implemented. Differences in regulations may lead to regulatory arbitrage and potentially a race to the bottom. Ineffective coordination between governmental departments may also hamper the effectiveness of implementation. The Financial Times reports that an alleged turf war between CBRC and PBOC is obstructing reforms and efforts to tackle risks in the financial sector⁸. In addition, regulatory capture may occur in the PRC, where political considerations prevail in some situations. These can result in the compromise of public interest over the commercial concerns of certain interest groups.

Macro-prudential Regulations vs. Micro-prudential Regulations

Moreover, shadow banking is a moving target, calling for flexible forward-looking approach to capture mutations of the shadow banking industry over time. Because of the nature of the shadow banking market, it is perhaps unwise to simply double up regulatory measures. After all, the emergence and growth of shadow banking market were market responses to the stringent banking market.

To solve this evolving problem, part of the answer lies in adopting macro-prudential measures, which are aimed at addressing systemic risks in the shadow banking system including pro-cyclicality etc.⁹ Focus should be set on the types of risks (stemming from the type of instruments) rather than on entities or activities. A combination of both micro- and macro-prudential tactics may be used. The current approach to capital adequacy is micro-prudential. Micro-prudential regulation consists of such measures as the certification of those working in the financial sector; rules on what assets can be held by whom; how instruments are listed, traded, sold and reported; and measures of the value and riskiness of assets. Such regulation concerns itself with the stability of individual entities and the protection of clients of the institutions. Micro-prudential regulation examines the responses of an individual bank to exogenous risks. It does not incorporate endogenous risk, and it neglects (disregards) the systemic implications of common behavior.

The spread of micro-prudential rules to non-banks such as insurance firms (Solvency II) and funds (sometimes via brokerage arrangements with regulated banks) tend to lead to homogeneous market behavior. However, in an interlinked and pro-cyclical system model, collective homogeneity can be disastrous. Regulators must be careful about the application of micro-prudential rules, especially those responding to market measures of value and risk, and ensure that they do not artificially create homogeneous behavior¹⁰.

Micro-prudential regulations identify specific activities or entities outside of the regulatory scope, as well as potential spill-over risks from the shadow banking system to the regular banking sector. However, actions apparently suitable at the level of individual institutions can destabilize the system as a whole, because of their interaction on financial markets, the structure of the network of which they are part, and the behavior of other financial institutions.

Macro-prudential measures seek to provide a broad picture of evolution of shadow banking over time, alert authorities to changes in the system that may not immediately be picked up from a micro perspective and identify funding vulnerabilities etc. One of the key purposes of macro-prudential policy is to address negative externalities by acting as a counter-prevailing force to the natural decline in measured risks in a boom, and the subsequent rise in measured risks in the downturn. It also aims to mitigate risks linked to financial sector concentration and interconnectedness. As such, macro-prudential policy has both a time dimension and a cross-sectional (or structural) dimension¹¹. A combination of both direct and indirect measures may also be adopted. Direct regulations aim at addressing risks stemming from shadow banking entities or shadow banking instruments, while indirect regulations seek to regulate the banks’ interactions with the shadow banking system as well as to close opportunities for regulatory arbitrage.

Introducing counter-cyclical bank provisions has already been done for some time in Spain and Portugal. The Spanish dynamic provision system requires higher provisions when credit grows more than the historical average, linking provisioning to the credit cycle. Under this system, provisions built up during an upswing can be accumulated in a fund. The fund of what they called ‘statistical provisions’ but would now be considered ‘macro-prudential provisions’ can be drawn down in a slump to cover loan losses. This counters the financial cycle as it discourages (although not eliminate) excessive lending in booms and strengthens banks for bad times. Counter-cyclical rules regarding changes in the credit exposure of financial institutions would also be helpful. In particular, financial institutions could be asked to increase provisions when there is excessive growth of credit relative to a benchmark, or a bias in lending toward sectors subject to strong cyclical swings (such as property mortgage or credit card lending). India adopted counter-cyclical provisioning requirements for lending in the housing market fairly similar to the Spanish approach, in that they were calibrated to increase in periods of rapid credit growth¹².

An alternative approach for counter-cyclical bank regulation through provisions is via capital. One proposal is to increase Basel II capital requirements by a ratio linked to recent growth of total bank assets. This provides a clear and simple rule for introducing counter-cyclicality into regulation of banks, which can be easily implemented. In this proposal, each bank would have a basic allowance for asset growth, linked to macro-economic variables, such as inflation and economic growth rate in the long-run. Growth above the basic allowance over the past year would have a 50 percent weight; growth over the year before that would have a 25 percent weight and so forth until 100 percent is approximated. Regulatory capital adequacy requirements could be raised by 0.33 percent for each 1 percent growth in bank asset values above the basic allowance. For example, if bank assets grew at a rate of 21 percent above the growth allowance, minimum capital requirements would rise from 8 percent to 15 percent. Given that credit cycles tend to be national, the application of counter-cyclical regulations needs to be on a host country basis. This would serve the added benefit of ameliorating the feast and famine of cross-border capital flows discussed hereunder¹³.

In his final speech as policymaker, the Deputy Governor of the Bank of England, Charlie Bean said that a key aspect of how macro-prudential regulations and micro-prudential regulations will work is that they may sometimes move differently and seem, erroneously, to be working at odds with each other¹⁴.

Global Efforts

More could come from global developments in regulations of shadow banking. On March 31, 2014, Mr. Shang Fulin, Chairman of the CBRC, attended the Plenary Meeting of the Financial Stability Board¹⁵ (“FSB”) held in London, together with approximately 70 senior representatives from member countries and international institutions¹⁶. One of the key issues being reviewed is the progress in core regulatory reforms of the global financing system in reinforcing oversight and regulation over shadow banking¹⁷. The FSB approved an information-sharing process among its members to support oversight and regulation of shadow banking entities other than money market funds. The FSB will start information sharing among authorities in May, and will launch a peer review on national implementation of the FSB's high-level policy framework in this policy area in 2015. The FSB also approved an implementation timetable for the policy recommendations to address financial stability risks associated with securities financing transactions that were published in August 2013. The FSB also reviewed the results of the public consultation and quantitative impact study on its proposed regulatory framework for cuts on non-centrally cleared securities financing transactions.

The FSB welcomed the finalization of the Basel Committee on Banking Supervision (“BCBS”) of its supervisory framework for large exposures, to be published shortly, and risk-sensitive capital requirements for banks' investments in equity of funds to mitigate spill-over effects between banks and shadow banking entities¹⁸. One of the aims is to transform shadow banking to transparent and resilient market-based financing¹⁹. Working to strengthen the oversight and regulation of shadow banking, the FSB has:

• Agreed on an information-sharing process to support implementation of the policy framework for oversight and regulation of shadow banking entities other than money market funds.
• Developed further the policy framework to address financial stability risks associated with securities financing transactions. This follows a review of the results of the public consultation and a further comprehensive quantitative impact study. An implementation timetable for the policy recommendations in this area has been agreed and will be published.
• In addition, the BCBS has finalized its supervisory framework for large exposures, to be published shortly, and risk-sensitive capital requirements for banks' investments in equity of funds, to mitigate spill-over effects between banks and shadow banking entities²⁰.

Conclusion

Ineffective regulations may do more harm than good, particularly when they lead to homogeneous behaviors that potentially lead to a collapse of the market. Macro-prudential measures may be apt to tackle issues for an evolving target such as shadow banking.

It is hoped that international effort will play a role in motivating the implementation of effective regulations and reforms in the PRC. That said, a series of potential political and economic hurdles (e.g. rivalry between China and Japan for regional hegemony) appeared to cast a shadow over the future of Asian financial cooperation²¹. The ambiguity and uncertainty inherent in changing global institutions and creating regional institutions has become a central driver of the current East Asian policy. It is also hard to conceive of a single set of regulations that would be appropriate for very different countries. China, Russia, Bermuda, Mexico and Peru all have different credit structures, financial needs and institutional capacity. Political priorities differ, too.