China's Road to Greater Financial Stability
Chapter

Chapter 10. Strengthening Macroprudential Management

Author(s):
Udaibir Das, Jonathan Fiechter, and Tao Sun
Published Date:
August 2013
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In recent years, the People’s Bank of China (PBC) and other relevant agencies have striven to deepen financial reforms, strengthen financial risk monitoring and assessment, and establish systems to prevent systemic risk and facilitate orderly resolutions. The aim is to ensure a stable operating environment for China’s financial system, taking into account domestic economic realities and keeping in step with the global regulatory reform agenda. A high priority has been placed on strengthening the overall macroprudential framework and improving mechanisms to maintain financial stability.

Role of the People’s Bank of China in Monitoring and Managing Systemic Risk

The Law of the People’s Republic of China on the People’s Bank of China, amended in 2003, entrusts the PBC with the important responsibility of “preventing and defusing systemic risk and maintaining financial stability.” To perform this statutory function the PBC has taken several steps toward monitoring and preventing systemic risks.

Progress toward a monitoring framework started in 2005, when the PBC began to publish its annual Financial Stability Report.1 The report has gradually helped establish a monitoring and assessment framework covering the macroeconomic environment, financial markets, banking, securities, and insurance sectors. The framework also reports on the financial condition of the government, the corporate sectors and households, and the financial market infrastructure. The PBC has adopted analytical techniques that combine quantitative and qualitative financial stability risk indicators. Since 2010, regular use has also been made of stress testing to bolster quantitative risk analysis.

Drawing on the lessons of the 2008 global financial crisis, the PBC has strengthened the monitoring of correlations between the macro economy and the financial system, as well as the domestic and cross-border interconnectedness of the financial system. Particular attention is being paid to potential cross-sectoral risks and cross-market financial products, systemically important financial institutions, and shadow banking operations. Using data from the interbank payment and settlement system, a financial network structure model has been built to capture interconnectedness among financial institutions and to dynamically analyze the liquidity risk transmission process among those institutions (primarily banks).

To institutionalize its stress-testing framework, the PBC has established a dedicated stress-testing team and initiated annual stress testing of 17 commercial banks. This includes stress testing of credit risk sensitivity and the macroeconomic scenario. The stress-test results show that, at present, the banking system has relatively high asset quality and capital adequacy, and relatively strong resilience to macroeconomic shocks.

At the regional level, the branches of the PBC have initiated onsite assessments of financial institutions, including in areas such as corporate governance, internal controls, primary operating risks, and contagion risk. This is facilitating an early identification of risks, liquidity stresses, and deterioration in asset quality.

China’s shadow banking system is relatively small and straightforward. The use and retailing of any derivative-type products is relatively rare. The PBC and its branches are continually monitoring risks from the shadow banking system. Steps are under way to collect data on a more regular basis and to develop a regulatory framework that would guide the healthy development of the shadow banking system in China in terms of wealth management products and entrusted loans, financial guarantee companies, pawn shops, private equity funds, and private lending.

Since 2009, the PBC, in collaboration with 11 other governmental agencies, has been subject to a comprehensive assessment of China’s financial stability by the International Monetary Fund and the World Bank. In 2011, their Financial Sector Assessment Program (FSAP) report affirmed the enormous accomplishments of China’s financial development in recent years. However, it urged China to continue to deepen financial reforms, accelerate the development of financial markets, strengthen the financial stability and crisis management framework, and improve the effectiveness of financial regulation.

Managing Systemic Risk

After the Asian financial crisis in 1997, there was commentary that China’s large commercial banks were in a state of “technical bankruptcy.” Since 2003, the PBC and the relevant agencies have resolutely promoted the joint-stock reform of large commercial banks. Accordingly, four steps have been undertaken and completed: writing off losses, stripping off nonperforming assets, using foreign exchange reserves to inject capital, and completing initial public offerings of the large commercial banks.

Through the reforms, the large commercial banks have gradually standardized corporate governance structures and continually improved internal control levels and product innovation capabilities. Profitability has grown relatively quickly and the value preservation of state-owned capital has improved. The success in the reform of large commercial banks has further propelled and encouraged the reform and development of “intermediate” financial institutions such as joint-stock and urban commercial banks. This has helped improve the competitiveness of the banking sector in China.

For over a decade, China has successively handled several financial risk events. The PBC has cooperated closely with the relevant agencies and local governments, adopting a variety of methods and policy measures, including mergers, restructuring, and bankruptcies, to effectively limit the systemic spread of financial risk.

A comprehensive overhaul of the trust industry included bankruptcy liquidation of the noted Guangdong International Trust and Investment Corporation, and restructuring and consolidation of all trust and investment companies engaged in illegal operations, facing a payment crisis, or unable to repay maturing debts. Through this overhaul, the number of trust and investment companies was reduced from over 200 to a few dozen. A similar approach was taken to cleaning up urban credit cooperatives and commercial banks. A comprehensive overhaul of securities companies has also been initiated, with 31 high-risk securities companies, including Southern Securities, shut down or declared bankrupt, and nine securities companies, including Galaxy Securities and China Securities, restructured. Market reforms have also been used to dispose of “DeLong Group” risk, which primarily involved production and financing risks.

The China Securities Investor Protection Fund and the China Insurance Protection Fund were established in August 2005 and September 2008, respectively, marking the establishment of a safety net for investors and policyholders. Since their formation, the two entities have participated in the resolution of weak securities and insurance companies. This has played an important role in maintaining social stability and in protecting the interests of investors.

Further Advances

China’s long-term economic outlook remains positive. However, there remain various financial imbalances and the issue of uncoordinated development and growth of the financial sector. Uncertainties also remain regarding the external sector. Macroprudential management thus needs further strengthening, and methods for systemic risk monitoring need to be improved. Some of these areas that need closer attention are discussed below.

A Framework for Macroprudential Management with Countercyclical Controls

In 2011, the PBC introduced a mechanism for the dynamic adjustments to differentiated reserve requirements, which is used in combination with routine monetary policy tools such as open-market operations, reserve requirement ratios, and interest rates. Dynamic adjustments to differentiated reserve requirements are based on the scale of social financing, the degree of divergence between bank credit and major socioeconomic development objectives, and the effect on the overall divergence of specific financial institutions. It takes into account such factors as the specific financial institution’s systemic importance and implementation of national credit policies. Relevant parameters may be adjusted quarterly to facilitate more targeted mobilization of excess liquidity so as to guide reasonable and stable extension of credit by financial institutions.

The core elements of the mechanism draw on two basic concepts of Basel III: countercyclical capital buffers and capital surcharge for systemically important financial institutions. The mechanism for the dynamically adjusted differentiated reserve requirement ratio can be expressed as a transparent, formulaic requirement that uses a flexible mechanism that strengthens risk prevention capabilities by increasing capital levels and improving asset quality. This reflects the requirements of macroeconomic management while achieving the purpose of preventing the accumulation of cyclical systemic risk and leaving room for market-based competition. Over the past years, the results of implementing this reserve requirement ratio have proven to be effective, and inflation has been notably restrained. This macroprudential policy is still at an exploratory stage and this framework will be further refined following the implementation of Basel III in China.

Analytical Methods for Monitoring Systemically Important Financial Institutions

Under this category comes the interplay between the financial sector and the real economy, making stress testing a routine financial stability tool, and establishing sound monitoring and assessment systems for the shadow banking system. This includes complying with international standards and norms, paying close attention to the assessment framework for domestic systemically important financial institutions, raising regulatory standards, refining orderly risk disposition and liquidation arrangements, strengthening shareholder and creditor assumption of liability for risk, and preventing the “too-big-to-fail” risk of financial institutions. For financial holding companies that have developed rather quickly and have become too big or too complex to fail, the PBC is instituting regulations, capital requirements, good corporate governance standards, limits on related-party transactions, and lower concentration risk. The overall goal is to reduce the probability and cost of bailouts.

Establishing a Deposit Insurance System

The global financial crisis reinforced the relevance of a well-designed deposit insurance system. A total of 47 countries used deposit insurance policies to prevent and defuse financial risk, protect depositor interests, and withstand the financial crisis. In June 2009, the International Association of Deposit Insurers and the Basel Committee on Banking Supervision jointly published Core Principles for Effective Deposit Insurance Systems.2 The principles were soon incorporated into the 12 core international financial standards by the Financial Stability Board.

The experiences of the United States and Europe demonstrate that outcomes of handling financial crises vary depending to a large degree on the design of the deposit insurance mechanism. Since 2008, nearly 400 banks have faced problems in the United States, but owing to timely and effective handling by the deposit insurance system the numerous bank failures did not trigger public panic, and stability was preserved in the banking system as a whole. The Dodd-Frank Wall Street Reform and Consumer Protection Act in the United States further authorized deposit insurance institutions to perform orderly liquidation of the risks of systemically important financial institutions.

China also attaches importance to depositor protection and has explicitly defined the objectives and requirements. At present, China’s macroeconomic environment remains stable, and the primary financial and regulatory indicators of China’s banking industry are largely healthy. The financial condition of rural credit cooperatives and other small institutions has improved substantially after reform and with policy support. All of these are advantageous conditions for the establishment of a deposit insurance system. In recent years, the PBC in concert with the relevant departments has studied the establishment of such a system. Drawing on the general requirements of international standards and the experiences of other countries, China should establish a properly funded deposit insurance system as rapidly as possible that makes insurance mandatory, employs differentiated premium rates, involves limited payments, and facilitates early correction of problem banks and risk disposition.

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