China regulatory revamp stills leaves scope for arbitrage

Financial regulation in China looks set to become more streamlined in a welcome development for markets, but without further reform there is still some scope for inconsistencies between different watchdogs. 

According to a proposal put forward by the State Council on Tuesday, the China Banking Regulatory Commission (CBRC) and China Insurance Regulatory Commission (CIRC) are to be merged into a new China Banking and Insurance Regulatory Commission (CBIRC). The proposal is expected to be passed by the ongoing National People’s Congress, which concludes on March 20.

Responsibility for drafting important new rules, formulating policies, and providing prudential oversight will shift from these two bodies to the People’s Bank of China (PBoC).

The aim is to establish a coordinated and effective regulatory framework to help deepen financial reform and close loopholes that allow firms to engage in regulatory arbitrage. But with the China Securities Regulatory Commission (CSRC) untouched, some experts believe the changes don't go far enough. 

The newly created entity will be responsible for enforcing rules, unlike the Financial Stability and Development Committee, the more senior body set up last July that now operates above both the central bank and CSRC, as well as the new CBIRC, experts say.

It’s a reasonable decision to combine the CBRC and CIRC and make the PBoC the overarching policymaking body, as the central bank overlooks liquidity conditions, credit risks, and interest rate risks across the whole financial system, Iris Pang, greater China economist at ING Wholesale Bank, told AsianInvestor.

However, the central bank may lack a thorough understanding of fast-evolving financial products as it has not been acting a regulator, she warned. The PBoC also needs to take a measured approach to tackle some of the mounting challenges in China's financial system, such as reining in shadow banking, Pang said.

TURF WAR

China’s four central financial regulators—the PBoC, CBRC, CSRC, and CIRC—together oversee assets worth a total of Rmb388 trillion ($61.3 trillion), or 468% of Chinese GDP, according to Deutsche Bank estimates. The CBRC and CIRC combined oversee Rmb330 trillion of assets.

The PBoC is mainly in charge of monetary policy, while the CBRC, CIRC, and CSRC supervise banks, insurers, and securities firms, respectively. The CSRC oversees the capital markets through which companies raise funds as well as providing institutional supervision and protecting retail investor interests.

That the CSRC is not being merged with the country's banking and insurance regulators suggests China's political powers believe capital markets supervision requires more specialist knowledge, Liao Qiang, senior director at S&P Global Ratings, told AsianInvestor.

However, there is a risk that the turf war between Chinese regulators will continue to play out if the CSRC is allowed to stand on its own, with potentially adverse consequences, Liao said. 

Regulators have conflicting objectives as they are mandated not only to supervise but to help financial markets develop. In some cases, due to the government's emphasis on growth, "regulators' supervision objectives were compromised and softened the regulations" as they raced for scale, according to Deutsche Bank.

To some extent, that can be seen in Chinese bond markets, with the exchange-traded bond market regulated by the CSRC and the China interbank bond market (CIBM) overseen by the central bank. Banks only participate in the CIBM but most corporates and institutional investors issue bonds and invest in both markets, and both the CSRC and PBoC want to grow the markets they oversee. 

In some cases, this has led to less stringent rules for some big issuers, Xia Le, Hong Kong-based economist at Banco Bilbao Vizcaya Argentaria SA, told AsianInvestor. He expects that the Financial Stability and Development Committee will step in to help resolve the problem of conflicting objectives. 

REGULATORY ARBITRAGE

Uncoordinated standards on similar financial products have encouraged firms to circumvent some of the rules, a market disorder that China hopes to combat with its regulatory overhaul. As long as the CSRC remains independent, though, the risk of regulatory arbitrage cannot be entirely snuffed out. 

For instance, the CBRC and CSRC impose different capital charges on the asset management products issued by trust companies, brokers, and fund subsidiaries.

Banks also often invest in wealth management products (WMPs) issued by other financial institutions, such as insurance companies and securities firms. The underlying assets of such WMPs are often loans to companies that cannot borrow funds via regulated channels.

Whilst they stay disunited, it will still be difficult for regulators to look through the products to properly assess the underlying assets, especially for products with different layers of special purpose vehicles.

A merged agency should be able to plug some of these regulatory loopholes, but further improvements are likely to be needed to address the many grey areas and adequately prevent systemic risks in the financial system.

“I don’t think the financial reform is finished after [the merger of CBRC and CIRC]. I think more details will be introduced to resolve such long-standing problems,” Liao of S&P said.