Basic rules helped China sidestep bank crisis.
By Liu Mingkang


Chairman,
China Banking Regulatory Commission
Since March 2003.

Published: June 28 2009

In an increasingly interconnected world, financial risks now spread like pandemics. One of the effective ways to prevent risk contagion is to set up firewalls between banking and capital markets.

Unfortunately, many people have forgotten this principle, or dispute it as “old-fashioned”. However, in China we have maintained such a firewall mechanism in our financial system reform. Only qualified commercial banks are allowed to participate in non-banking activities, and have strict firewalls separating them. We insist that the main funding source of banks should always come from deposits. On top of that, the China Banking Regulatory Commission (CBRC) is developing a regulation that would require firewalls to be established between commercial banks and their controlling shareholders and between commercial banks and their non-banking subsidiaries, in order to prevent risk contagion.

Sometimes the most effective way to address a complex issue is by using basic, simple but useful measures. Practice shows us that traditional tools work, especially considering that financial engineering can malfunction. In recent months we have noticed that many regulators in the rest of the world have also started to embrace this “back to basics” approach.

Much has been written about what triggered the global financial crisis, but in my view it can be attributed to five factors. First of all, the firewall between capital and banking markets was eroded by unsound financial innovations. Second, macro-prudential regulation was neglected. Third, financial institutions had too much leverage and were too opaque. Fourth, incentives for staff at financial institutions were driven by short-term gains, rather than long-term benefits. Fifth, the bail-out put the cart before the horse by pumping in capital and liquidity before cleaning up balance sheets.

Today, China’s financial system looks quite different from its western counterparts. Between 2003 and 2008, total banking assets have increased by Rmb34,700bn ($5,084bn, €3,620bn), up 1.3 times, while profits in the banking sector have risen by Rmb521.8bn, a 17-fold increase. The better shape of the Chinese banking sector can partly be attributed to China’s prudential banking regulation. We believe banks are deeply rooted in the real economy and while the financial sector can temporarily outpace the real economy, this cannot continue for ever.

In Chinese we say jian mu bu jian lin , meaning one who sees only the trees and misses the forest. As banking regulators we have always seen it as our responsibility to look at the whole system as an organic body since individual banks sometimes ignore or lack the means to look at risks at a systemic level. It has been our practice to conduct industrial assessments, monitor changes and alert banks with the findings to the potential systemic risks. We also take measures to prevent cross-market and cross-border risk contagion.

It is clear that when hordes of market players move in the same direction it will often result in irrational exuberance and a herd mentality. That is why supervisors must always play an important role. We believe it would be a bad mistake for super­visors to stay aloof. In China we trust those we regulate but always check what they tell us and retain the authority for a final inspection, especially on innovative financial products.

It is never an easy job to be a regulator in China, and even more difficult to be a good regulator. Despite our remarkable progress, the Chinese banking sector still confronts Herculean tasks. This year will undoubtedly be a tough one for China’s economy. Banking institutions will find themselves in a more stressed environment. In this regard, more has to be done to improve corporate governance, internal controls, risk management, staff training and supervision expertise. For years, the CBRC has been upgrading its ability by drawing from international best practices while rooting its knowledge in the Chinese situation. The CBRC has recently been invited to join the Basel committee on banking supervision as well as the new Financial Stability Board. We will use these positions as an opportunity to share views, draw lessons and contribute to enhancing supervision both in China and internationally. Together, we will build a more efficient and transparent international financial system.