From new restrictions on the sale of Universal Life (UL) insurance products by the China Insurance Regulatory Commission (CIRC), the indefinite suspension of the initial public offering (IPO) shelf registration system, the stock market circuit breaker system, the postponement of the new Shanghai stock exchange growth board by the China Securities Regulatory Commission (CSRC), to the rolling out of “Draft rules for online lending” and the launch of a national audit on peer to peer (P2P) lending platforms by the China Banking Regulatory Commission (CBRC), China’s three financial sector regulators are launching major reviews of new innovations implemented in the past few years that have been blamed for the chaos in the financial sector in the second half of last year and early this year. The extent of remedial measures put up are sober reminders that these major innovations have failed in their initial forms. Recent stability in the financial market can be attributed to the restoration of a certain degree of confidence in the effectiveness of these remedial measures. However, people are still asking why there were so many missteps and why they were adopted in the first place.
Aside from the officially acknowledged reason of coordination failures among the regulators that provided speculators with policy arbitrage opportunities resulting in the ultimate market meltdown (Chan, 2016a), the recently appointed chairman of the CSRC, Liu Shiyu, explained the CSRC policies’ suspension as being due to the absence of complementary measures to make the original policies work (“China Watchdog Takes”, 2016). This emphasis on the sequencing of reforms is a new vantage point to look at the meltdown and offer valuable lessons to understand why the policies’ missteps were committed.
How Chinese Innovations Differ from Overseas Cousins
The UL, IPO shelf registration system, stock market circuit breaker, growth board, and P2P lending were all ideas that originated from other countries, and while they were not all successful overseas, they nevertheless did not create that much market disruptions as in China. Liu’s observation of the poor complementary policy environment highlighted one of the main issues facing China.
In the case of UL, many jurisdictions have not allowed its sale as the product gives insurance companies too much leeway in directing the investment destination, creating moral hazard issues. In the case of the US, which pioneered the product at the turn of the century, strict implementation of the early policy redemption penalty made the product a real long term life insurance policy, whereas in China, twisting the term of product redemption essentially turned the life insurance product into a short term wealth management product with high indicated promised returns (Chan, 2016b).
In the case of the stock market circuit breaker, setting the market breaker at 5 percent and 7 percent essentially made hitting the market suspension button almost a certainty in a market meltdown, as the Chinese market also implements a 10 percent individual share suspension system. Running the old system plus the new system just led to a mutual reinforcement of the two systems in price volatility, and the triggering of the circuit breaker become a fait accompli. The Chinese stock market increased its volatility in the second half of last year, and daily suspensions of many stocks under the 10 percent volatility rule have become commonplace. Introducing such a policy under such a background was indeed a careless step.
For the shelf registration system, the anchor premises for its successful implementation was an effective self-regulating stock exchange and highly reliable IPO documentation. It is common knowledge in China that both conditions do not exist at the moment. Stripping the CSRC’s power to approve IPOs and relying on the stock exchange’s self-governing ability may minimize bureaucratic inefficiency, but the chance of a bigger fiasco down the road is very high as the reliability of the stock exchange as a gatekeeper is even worse than the CSRC’s.
For the Shanghai growth board, if one checks the records of the Shenzhen growth board and the subsequent corporate performance of the listed companies, whether the country needs another growth board under the current setup remains a matter of public debate.
For the P2P platform, the mystery remains why the CBRC only published its drafted rules for online lending in December 28, 2015, after more than 25 percent of P2P platforms had gone belly up, and the sector had amassed more than RMB 400 billion in assets. P2P appeared as a powerful funding platform in 2013 and the prolonged regulatory vacuum on P2P platforms remains an unanswered question. In the face of a still increasing P2P platform default with many closures attributed to fraught, Chinese regulators have suffered serious reputational damage. No other country takes P2P platforms as seriously as China and unfortunately, Chinese savers suffer the most when it boomerangs.
Why Regulatory Failure Happens?
Many observers attributed the regulatory failure to a combination of factors. First is that vested interest groups had hijacked the introduction of the innovations and intentionally left gaps for their policy arbitrations. Second is the bureaucratic inertia that failed to detect hidden problems with the new products and reacted only when the situation had reached the boiling point. Third is the enthusiasm for the innovations which made the regulators focus only on the positive side of things and forget Murphy’s law. Fourth is the highly technical nature of financial sector work which causes regulators to always fall behind the curve, reacting either too little or too late. We are not privy to the internal discussions of the regulators but it is reasonable to believe that probably all factors contributed to the failure.
How Regulators Should Proceed
Several valuable lessons emerged from the recent fiasco.
First, China’s financial sector is unique. Understanding the unique background of the Chinese financial sector is important in deciding what are the good policies and innovations to draw from overseas markets and what should not be touched. Financial sector decision making is based on available documentation. It is an information business and vulnerable to information fraud. Many of the dependable documents available overseas are often absent in China. The fraud committed by the infamous eZuBao is a classic case: the perpetrator paid almost a billion RMB to buy cases of corporate fund raising information from corporate insiders and used it for online applications for project funding. There is no way for big data to detect such fraud as the information is authentic but is being misused. In a short period of 18 months, eZuBao duped 900 thousand investors of RMB 50 billion, with 90 percent of cases presented on its platform arranged the abovementioned way. Chinese investment behavior is also unique; rumours are common and they drive the market in many instances. Understanding the psychological aspect of economic decision-making in China is as important as rational model trajectory, or even more critical in some cases.
Understanding the unique background of the Chinese financial sector is important in deciding what are the good policies and innovations to draw from overseas markets and what should not be touched.
Second, China’s current financial sector is so integrated that regulations must be implemented across sectors concurrently. There have been many instances of financial sector players exploiting regulatory time lag between sectors to profit from arbitrage opportunity, a recent example being the shift of stock margin-financing activities (场内配资) from securities firms to banks’ wealth management products (WMP) when CSRC tightened up in the first half of 2015. This shift happened because CBRC is not regulating bank’s WMP stock margin financing activities at that time, resulting in unregulated build-up of WMP margin financing. This was one of the main reasons behind the irrational surge and subsequent collapse of stock market in 2015.
The coordination issue was noticed earlier and there were attempts in 2003 and 2008 among People’s Bank of China (PBoC), CSRC, CBRC, and CIRC to setup informal or formal mechanisms to address the issue of policy coordination and minimize regulatory arbitrage opportunity of unscrupulous financial market participants. Unfortunately, both these efforts failed as the four participating agencies were too keen to protect their respective regulatory turf. The failure behind the last attempt in 2013 to work out the problem is particularly poignant. The effort was directed by the State Council and PBoC was the designated leader to work out the coordination issue. However, even with a higher authority imposing an order of formal coordination mechanism, the effort still failed. Until a super financial oversight structure is setup to run synchronized policies in different financial sectors, perennial regulatory arbitrage issues will make any financial sector innovations a potential time bomb down the road.
Third, the decision to proceed with innovation should be based on its chance of success, and all coordinating policies should be in place before the reforms proceed. We have noted the difference between Chinese financial innovation and their overseas cousins. If China believes the innovation is indeed good, it should not rush the innovation until all complements are in place. A well-meaning innovation will not automatically deliver success until they are implemented well on the ground, while slight deviations may blow the innovation off the ground. Pay attention to details as the devil is always in the details.
Fourth, entrenched interests are a significant problem in the Chinese financial sector and care should be exercised when policies are formulated to prevent them from being hijacked. The spate of arrests of many prominent personalities on insider trading charges after the crisis, and the revelation of rampant regulatory arbitrage by insurance players in the past few weeks, point to the extent of the problems. China has vibrant internet discussion communities and vested interests have a strong voice in these forums. Public discussion of financial reforms is often dominated by a single track thinking of liberalization and anything associated with “innovation” is automatically accorded “right” status. Either because the thinking is twisted by disappointment over earlier government failures or planted by vested interests, the public forums on financial reforms are not very sound at the moment. We can only hope the new emphasis announced in the last National People’s Congress by the chief prosecutor and supreme court judge on cracking down financial crimes will mitigate the future influence of vested interest groups.
Chan, H. (2016a, March 21). Is the Super Central Bank Model Coming to China? IPP Review. Retrieved from http://ippreview.com/index.php/Home/Blog/single/id/67.html
Chan, H. (2016b, March 28). Changing Regulatory Philosophy? Chinese Regulators Seek to De-Risk Insurance Products after NPC. IPP Review. Retrieved from http://ippreview.com/index.php/Home/Article/single/id/15.html
China Watchdog Takes It Slow on IPO Reform, Vows Stock Help. (2016, March 14). Bloomberg. Retrieved from http://www.bloomberg.com/news/articles/2016-03-13/china-s-head-regulator-offers-stock-investors-welcome-respite