Coping with Financial Risk

From: English Edition of Qiushi Journal Updated: 2011-09-20 11:38
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 Finance is the nucleus of a modern economy. Our experience in coping with the current international financial crisis has taught us that we must impose restrictions on banks to prevent financial risks and consolidate the foundation for the stable and sound operation of banks. These efforts will allow us to safeguard national financial security.

 I. We are stipulating reasonable boundaries to ensure the safe operation of the virtual economy.

 The relationship between the virtual economy and the real economy is a unity of opposites. On the one hand, the healthy operation of the virtual economy improves the efficiency of resource allocation, thereby promoting development of the real economy. On the other hand, the emergence of a problem in the virtual economy will not only hinder the development of the real economy, but will also pose a serious risk to the real economy. Therefore, the key to preventing systemic risk in the economy is to understand the laws governing development of the virtual economy in relation to development of the real economy.

 China has worked hard to reduce systemic risk by introducing a set of benchmarks and indicators in the course of deepening banking reform. In recent years, the China Banking Regulatory Commission (CBRC) has developed a set of criteria to ensure prudent operation of banks based on the Basel Accord and other related international regulations. These define regulatory objectives and minimum requirements for capital adequacy ratio, ratio of non-performing loans, provision coverage and loan-deposit ratio, which have played an important role in preventing systemic risk in the banking industry.

 In addition, we have continuously adjusted and reformed the concepts, framework and technology of financial oversight and implemented dynamic, differentiated and counter-cyclical management in line with changes in economic performance, development levels of different regions and the nature and scale of financial institutions. When faced with excessive expansion of credit and threat of impending risk last year, for example, we raised the provision coverage for large banks from 100% to 150% and raised their capital adequacy ratio to 11.5%.

  Employees of the Bank of China provide financial advice to urban residents on Tiyuchang Road in Ningpo City, Zhejiang Province on November 28, 2010. This day is “Public Education and Service Day” of the Chinese banking industry, and banks in Ningpo City set up stations at selected points in 28 urban sub-districts and communities in the city to provide the public with financial information and inform them about financial risks to strengthen their sense of financial security. / Photo supplied by Xinhua

 II. We are working to prevent liquidity risk in large financial institutions. 

 During the current global financial crisis, the US government and the British government immediately aided large financial institutions such as Citibank and the Royal Bank of Scotland when they ran into difficulty. Experience has shown that the “too-big-to-let-fail” rule plays a very important role in maintaining the stability of the financial system. 

 For a long time we focused too much on credit management, but failed to pay enough attention to liquidity risk. On the one hand, China’s high savings rate provides adequate funds for banks, causing us to neglect liquidity regulation. On the other hand, depositors believe that the government provides an implicit guarantee for the funds of state-owned banks and therefore need not worry about liquidity. These ideas are incorrect. The emergence of liquidity problems in banks, especially large banks, can easily shake market confidence. Therefore, we must set a strict minimum level of liquidity to ensure long-term stability and sound operation of large banks.

 We need to address both symptoms and root causes to reduce liquidity risk. Large banks not only need to follow the regulatory guidelines and minimum requirements but also adhere to the Scientific Outlook on Development. The “too-big-to-let-fail” rule should not become a perverse incentive for large banks to blindly expand their scale and arbitrarily enlarge financial leverage. We must take special measures to regulate large banks. We must make the lower limit for liquidity stricter, adopt more prudent policies, prudently control the leverage ratio and set the pace of growth at a reasonable level to ensure that the expansion of banks is in line with their capital level and management capability.

 III. We are setting limits to ensure the sustainable development of banks.

 An analysis of this global financial crisis shows that excessive attention paid to immediate financial performance and profit growth and shareholder returns is one of the deep-rooted causes of this crisis. This value orientation leads to the prevalence of short-term behavior and speculation. We must attach more importance to the sustainable development of banks and improve the fundamental quality of the banking industry to prevent bankruptcies. This should become the core value of our regulation as well as the core value of operation and risk management in the banking industry.

 China’s banking industry has withstood the test of the international financial crisis. This does not mean, however, that all of China’s commercial banks have the ability to ensure sustainable development. Handling crisis is undoubtedly important to bank regulation, but it is even more important to develop a mechanism for normal management and establish a set of minimum risk levels to prevent bankruptcies. These mechanisms and minimums help banks in self-restraint and encourage them to take preventive actions before a crisis occurs.

 Experience has shown that we must take the following into consideration when setting limits to keep banks from fatal risks. First, banks should meet the minimum capital requirements because the amount of capital determines the scale of business. Second, banks should develop a risk-absorbing and flexible assets structure to ensure risk diversification. Third, banks should ensure that profits far outweigh risks to ensure strong resilience to risk. Fourth, we should develop a sound mechanism for management and operation of banks to make the development strategy of banks more scientific and more foresighted. Fifth, we need to establish an incentive and restraint mechanism in line with the characteristics of banking management and operation to avoid short-term behavior and perverse incentives, thereby reducing irresponsible ventures on the part of banks.

 IV. We are taking measures to prevent risk in one sector from impacting other sectors in carrying out cross-sector financial activities.

 Quite a few banks in China have been experimenting in cross-sector financial activities in recent years. Eight banks have set up fund management firms, four banks have been given permission to buy stock in insurance companies on a trial basis, seven banks have established financial leasing companies or bought stock in such companies and two banks have set up trust companies. It should be said that cross-sector financial activities help banks break away from their traditional business model of merely relying on interest differentials and increase their ability to serve customers to realize a certain degree of synergy.

 However, cross-sector financial activities blur the division of labor among financial institutions. This reduces the transparency of their operations and leads to conflicts of interest and insider trading, thus greatly increasing the possibility of spreading financial risk to different sectors. Therefore, we are setting stringent risk limits to prevent risk spreading across sectors, mainly through “risk firewalls” and a professional oversight system for the banking, securities and insurance industries. First, we are establishing a firewall system to prevent risk in one sector or market from impacting others. Second, we are strengthening oversight for the banking, securities and insurance industries and making oversight more professional.

 China is now gradually allowing banks to engage in cross-sector financial activities. It would be inappropriate to put too much emphasis on the synergy effect when there is not enough competition in the financial sector. China’s banking industry will follow a basic principle of concentrating on bank operation for the foreseeable future.

 V. We will reserve the right to control our own financial institutions in opening up the banking sector. 

 Experience has shown that we must safeguard the country’s core interests and adhere to a principle of independence in opening up the banking sector. This is a valuable lesson as well as an important principle for us to follow from beginning to end.

 We must first of all adhere to a principle of independence and autonomy in carrying out the country’s strategy of allowing foreign banks to operate in China. Some countries in Central and Eastern Europe have lost the right to control their domestic banks. This is an important reason why they suffered more than many other countries from the impact of this international financial crisis. Faced with this crisis, the financial systems of these countries were trapped due to large-scale divestment on the part of Western financial institutions. These lessons tell us that we must reserve the right to control the financial sector, and in particular we must retain the right to be the absolute majority shareholder in the large banks. This is crucial to financial security as well as national economic security so we must always bear this in mind.

 We must ensure that China’s banks adhere to four cardinal principles in the implementation of the country’s “go global” strategy. First, China’s banks must follow a strategy of self-development and promote self-development. Second, China’s banks must stay in tune with the real economy, in principle offering banking services wherever there are customers for them, and should not invest in financial institutions outside the banking industry. Third, China’s banks must maintain enough equity so they can have the capital needed to do business. Fourth, China’s banks must develop the ability to manage international financial institutions, including the ability to assess and control the risks presented by a particular country and project. While the country is carrying out a strategy of allowing foreign banks to operate in China, China’s banks should be paying close attention to the domestic situation to lay a solid foundation for “going out” in the future. 

 VI. We are improving the system for information disclosure concerning potential bank risk.

 The flow of information concerning bank risk conditions and key affairs related to risk must be symmetric between regulatory departments and banks as well as between banks and the public. To accomplish this, regulatory departments need to improve on-site and off-site oversight and inspection and banks need to take more initiative in releasing information related to risk. The China Banking Regulatory Commission issued the Guidelines on Releasing Information on the Capital Adequacy of Commercial Banks in 2009, which contains detailed regulations concerning release of key information. These guidelines define the minimum requirements for oversight and the orientation of oversight in the future. 

 For a long time we focused much on oversight to ensure the authenticity of information, especially on the authenticity of credit risk rating. If we cannot ensure the authenticity of the information and the accuracy of credit risk rating, even to the extent that such information and rating contains major discrepancies, there will be no dependable basis for assessing a bank’s assets, profits, capital adequacy ratio, return on equity and tax revenue, thereby posing potential risks. The China Banking Regulatory Commission is constantly working to strengthen oversight to ensure authenticity of information and looking for new ways to incorporate the deviation tolerance for non-performing loans in calculating risk indicators. 

 VII. We are working to closely integrate oversight and innovation.

 The relationship between oversight and innovation can be seen as opponents in a game. An important motive for financial innovation in the banking industry is to circumvent regulatory requirements to maximize gains. By standardizing the rules for and carefully guiding this game, we can improve the efficiency of finance and create a win-win situation for everyone involved.

 To address the current situation, we are setting three limits for banks making innovations. One, we are adopting regulatory measures so that all the allowed innovative activities of banks have a legal framework. This is a rigid restriction. Two, we are setting a maximum leverage ratio, strictly limiting the amount by which commercial banks can increase their leverage ratio through innovations and prohibiting banks from providing explicit or implicit guarantees that would raise their risk level. Three, we are setting a minimum level of transparency, requiring banks be open and transparent in making financial innovations by disclosing relevant information such as the deal structure, how the capital is to be invested and potential risk to regulatory agencies and customers.

 China has just begun working out measures to limit the risk banks are allowed to create through financial innovations. We are standardizing innovations by setting limits and encouraging banks to make full use of their wisdom to make innovations within these limits. Financial innovations help banks meet the diverse financial needs of enterprises and individuals, develop new profit growth areas and provide powerful financial services that stimulate domestic demand and economic growth.

(From Qiushi, Chinese edition, No.14, 2010)

Note: Author: Vice Chairman of the China Banking Regulatory Commission

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