One of China’s toughest and longstanding economic challenges has been the need to slow runaway credit growth, much of it fueled by speculative investments that do not contribute to the real economy. After years of uncertainty over possible reforms of the financial regulatory system, the National People’s Congress moved on March 13 to merge the banking and insurance regulators and delegate more policymaking authority to the central bank (People's Bank of China, or PBOC). It was a welcome step that will help address the credit problem by setting up a more function-based rather than organization-based regulatory system. The plan should also improve coordination among regulators and delineate clearer divisions of responsibility between them.
Evolution of China's Fragmented Regulatory Landscape
The current structure is sometimes called “one bank and three commissions.” It has been in place since 2003, when the China Banking Regulatory Commission (CBRC) was carved out of the PBOC. The creation of the CBRC was the culmination of a decade-long process that created the China Securities Regulatory Commission (CSRC) in 1992 and the China Insurance Regulatory Commission (CIRC) in 1998. In the early 2000s China’s banks were reeling from a mountain of bad loans that required enormous bailouts to keep them in business, and looming entry of foreign competition opened up by China’s accession to the World Trade Organization (WTO). Banks and their regulators needed modernization. Specialized, professional regulators for what were then far more clearly distinct businesses—banks, insurance, and securities companies—seemed to be part of the answer.
But the specialized regulation approach has been flawed by serious shortcomings. The rise of shadow banking, especially after 2008, has produced firms and products that often blur the lines between banking, insurance, and securities. The siloed supervisory structure made it virtually impossible to effectively regulate these hybrid institutions that often managed to fall between jurisdictions. The central bank is “first among equals” in this structure, but it does not have authority over the three commissions to coordinate regulatory efforts and handle a constantly changing, more complex financial sector. Fragmentation also made it difficult to take a systemic, macroprudential approach to regulation—one that takes different areas of the financial system and their linkages into account.
China Streamlines Regulation by Focusing on Function Rather than Company Type
The government has debated various reform ideas for years, including proposals (eventually rejected) to merge the regulatory functions into a single “super regulator.” Instead of trying to merge four organizations with so many competing interests, government officials came up with a compromise. In November 2017, they created the Financial Stability and Development Committee directly under the State Council, headed by a vice premier more highly ranked than the heads of the regulatory agencies and the PBOC. The role of the new committee is to coordinate overall strategy for the financial sector and formulate policy at a high level.
The new reorganization will streamline policymaking and implementation below the committee level. Instead of separate regulators for each type of company (insurance, banking, etc.), separate regulators will oversee policy formulation and its day-to-day implementation, which includes monitoring compliance. The PBOC will take over the legislative and rulemaking functions of the CBRC and CIRC, a significant increase in power. Since the new combined banking and insurance regulator will be only an implementer of policy—no longer also formulating it—there will be two (the central bank and the securities regulatory commission) rather than four ministry-level policymaking bodies. The result is fewer overlapping, unclear jurisdictions. The overall push for deleveraging and reduction of financial risk is now more credible because financial firms will find it harder to shop for lighter touch regulation by shuffling the same economic functions to a different type of company.
Financial crises throughout history have taught us that destabilizing conflicts of interest tend to arise when a single regulatory body is responsible both for the system and for the oversight and soundness of individual institutions. Regulators can be afraid to undertake urgently needed tightening of their system-wide policies like interest rates and capital requirements if they know that some financial institutions they are responsible for overseeing will fail as a result, because the blame will be placed squarely on their shoulders. Conversely, a regulator may fail to crack down on a reckless bank flouting the rules if it fears doing so could threaten the stability of the system. The new structure in China attenuates the contradiction by housing these functions in separate institutions, which better aligns their incentives.
Integrating Faltering Regulator Parallels US Example
Though it may seem novel to integrate banking and insurance, it is generally accepted by policymakers and academics globally that both bank depositors and insurance policyholders should be protected from risk in a similar way, through heavy regulation around risk taking and capital adequacy. Securities regulation tends instead to focus on transparency and proper functioning of markets, where customers realize they are taking on risk if investments go south.
The combination of the CIRC and the CBRC follows examples from outside China and is in many ways like the 2011 absorption of the Office of Thrift Supervision (OTS) into the Office of the Controller of the Currency (OCC) in the United States. The OTS is widely cited as an example of “regulatory capture,” when an agency becomes the cheerleader rather than a referee for the industry it is supposed to regulate. Financial institutions engaged in jurisdiction shopping, reorganizing as thrifts under the OTS to get lighter regulatory burdens. The results in the financial crisis were disastrous, as many of them failed and taxpayers shouldered their losses.
In China, the CIRC started deregulating insurance in 2002, when it allowed insurance companies to invest in many new types of assets and issue short-term insurance policies that resembled risky investments. In late 2015 it liberalized further, unleashing a massive offshore buying spree by the giant, politically connected Anbang, among other companies. Like most booms, this frenzy created serious problems. In April 2017, the CIRC’s chairman was investigated for corruption and removed from his post. The government is still cleaning up the mess created by the regulatory capture, including recently taking control of Anbang, which owns the Waldorf Astoria in New York and a broad range of other offshore assets. Its buying spree appears to have brought it to the brink of bankruptcy. Like the OTS, the troubled CIRC is effectively being eliminated and its functions handed to a stronger regulator. As in the United States, the merger process is sure to be an acrimonious process with wrangling over posts and turf that takes years to complete.
But many questions remain. One is how this reorganization will change relations between financial regulatory authorities at the local and national levels. Under-resourced local officials have been primarily responsible for the day-to-day regulation of financial institutions in their jurisdictions, implementing policies determined by regulators like the CBRC in Beijing. The national reorganization may further centralize authority at the national level to prevent a different type of jurisdiction shopping, in which financial firms choose to locate where local governments are pliant. Another question is the future of the CSRC, which remains independent for now but exists next to a much more powerful central bank. It is also unclear how the reorganization will affect the financial technology firms that have grown to become the world’s largest, thanks partly to the space granted them by poorly coordinated regulators.
Overall, these reforms are good news for financial stability in China.