Code of conduct needed to reduce moral hazard

By Li Honghan Source:Global Times Published: 2017/7/27 21:28:39

Illustration: Peter C. Espina/GT


There is growing consensus that it is of critical significance to make accurate evaluations and predictions of systemic risks facing the Chinese economy. And it is believed that a prudent yet tougher stance toward the country's financial sector oversight and overseas investment will turn out to be a powerful means of ensuring China's financial security and guarding the country against systemic risks.

The added value of China's financial sector as a percentage of the country's GDP hit 8.4 percent at the end of 2016. The ratio is higher than that what's seen in many developed economies such as the US and Japan and roughly equals to the added value of the US financial sector in the year prior to the subprime mortgage collapse as a proportion of the US GDP for the year. In other words, the ratio in China has outnumbered the figures in many developed countries relying on the financial sector as a mainstay of their economies and has surely exceeded the tolerable level of risk for developing countries including China.

Currently, the risks to China's financial sector mainly emanate from the sector's transition toward hybrid operations, the sector's incorporation into the Internet, and innovation. Meanwhile, the financial regulatory regime in which separate agencies oversee different parts of the financial sector has debunked a variety of maladies. This means the traditional financial oversight framework faces a huge challenge. First, banks, worried by either relatively high levels of nonperforming loans (NPLs) or potentially high NPL ratios, are at risk for transformation bottlenecks. Second, non-bank financial institutions are confronted by the risks of regulatory arbitrage and ballooning leverage trading. Third, private finance in the country that comprises Internet finance and various local asset trading platforms faces the risk of excessive financial innovation. Also, financial risks are seen coming from regulatory policy changes, credit and social financing, and fluctuations in foreign exchange rates, bulk commodity prices and property prices, among others. 

On top of that, Internet finance as a latent source of systemic risk has gradually come to light. From the advent of online finance back in 2011 up till now, Internet-based financial transactions have seen swift growth, with the compound annual growth rate exceeding 150 percent in terms of transaction value. Last year, the country had more than 500 million Internet finance users and its Internet finance sector totaled 17.8 trillion yuan ($2.64 trillion) in transaction value, accounting for nearly 20 percent of the country's GDP. The massive user base, as such, renders Internet finance risk highly contagious and could easily spread the risk into traditional financial institutions and those susceptible to financial risks. This might be particularly the case factoring the country's shift toward a cashless society and the growing popularity and penetration of mobile payment and online wealth management products among the mass of people. In light of this, once Internet finance is exposed to risks mass user confidence in finance and consumption will collapse and result in severe systemic risks.

There is a saying that it's never too late to mend. To spot the loopholes and rectify them can prevent systemic risks from further spreading and worsening. There are three main problems in the current separate regulatory regime: regulatory void, overlap, and arbitrage. The emergence of various financial innovations has in particular given prominence to the oversight issue in which financial innovation in many areas such as banking, securities, funds and insurance creates regulatory void and then makes room for regulatory arbitrage. In addition, under the separate oversight framework, a single product is likely to be put under the purview of many regulatory agencies, leading to regulatory overlap and void. 

That said, the establishment of trans-sectoral oversight and review of traditional industries' overseas investment are necessary requirements for the country to stay secured against systemic risks that gradually emerge in its financial sector. In this regard, the recently concluded National Financial Work Conference shows great foresight. The finance meeting, held only once in every five years, highlighted that the financial sector should serve the real economy and emphasized the impact of financial risks on the current economic landscape. Against the backdrop of hybrid operations and de-regulation, it's inevitable to ramp up the transition toward functional oversight from the current agency-based oversight. Additionally, regulatory agencies should keep an eye on the continued development of financial innovations and keep pace with financial innovations in order to prevent regulatory delay and void. Furthermore, the country needs to learn from the experience of others to build an effective regulatory framework that is capable of preventing and controlling risks, as well as fostering financial operations.

The trans-sectoral oversight pushed by the central government and the review of overseas investment by firms in traditional sectors are thus putting a powerful grip on capital excessively obsessed with profit maximization. Considering that capital would always keep pursuing high yields and evade regulations, it's thus a helpful means to enable a penetration of regulatory oversight by stepping up efforts to put in place a code of conduct and increase the awareness of moral hazard for financial sector participants. Meanwhile, there needs to be increased coordination and linkage between different regulatory bodies so as to spot and correct flaws in the existing regulatory system in a timely manner.

Having said all this, it needs to be noted that efforts to build trans-sectoral oversight and review overseas investment should avoid becoming a mere formality, which means the regulatory goals and responsibilities must be clarified. The goal of trans-sectoral oversight is to prevent financial risks and have the finance sector better support the real economy. Other than that, the financial stability and development commission, announced at the National Financial Work Conference, is supposed to be above the current regulatory framework consisting of the central bank and three main regulatory bodies overseeing the banking, securities and insurance industries. The new commission will assume the responsibility of coordinating and overseeing the central bank and the three regulatory bodies, the fulfillment of which is indispensable for systemic risk prevention.

The author is a research fellow at the International Monetary Institute (IMI) of Renmin University of China and manager of Asset Management at Hua Xia Bank.

Posted in: INSIDER'S EYE

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