PBOC Research Chief Weighs in on China’s Regulatory Challenges


Xu Zhong, the head of the People’s Bank of China’s research department, outlined the many difficulties faced by Chinese financial regulators during a key transitional period for the country’s economy during a keynote speech delivered at the Lujiazui Forum in Shanghai.

Featured below is an abridged translation of Xu Zhong’s speech on financial and banking regulation that he delivered on 21 June at the 2017 Lujiazui Forum.

“Looking at things domestically, following the economy’s entry into a new state, from the money drought to Internet financial risk, from the share disaster to the bond market storm, regional financial risks have exploded repeatedly, and continually revealed deep flaws in Chinese financial regulation.

“Financial regulation continually develops and evolves in tandem with the development of financial markets. Early financial regulation was implemented spontaneously by the market itself. For example, the 1792 Wall Street Buttonwood Agreement launched self-regulation by the US securities sector. In 1907 private banker J.P. Morgan took the initiative in organising private banks to jointly respond to a financial panic, which eventually led to the birth of the US Federal Reserve. The Bank of England, the UK’s central bank, at its inception was a private bank.

“Following continual increases in the frequency and intensity of financial panics, especially  after the Great depression, people are aware of the huge external as well economic and social cost of financial crises, and that reliance alone on market self-regulation is unable to compensate for market malfunctions or prevent systemic financial risk. In theory, economists have affirmed the importance of public participation in financial regulation from the perspective of balancing the costs and benefits of regulation.

“In practice, based on the consideration of reducing the externality of crises, central banks evolved into ‘lenders of last resort,’ and thus performed supervision and inspection of the business activities of financial institutions, achieving a shift in financial regulation from private sector self-regulation by the market, to supervision and regulation by the public sector.

“After the Second World War and following the success of Keynesian government intervention, financial regulation was heavy and prioritised safety, and strict financial regulatory systems were implemented in general, which caused severe financial repression and loss of efficiency.

“Once Keynesianism was rebuffed by the stagflation of the 1970’s, financial regulatory theory began to consider the limitations of financial regulatory systems, producing theories and explanations about regulatory malfunctions that pointed to supply-demand imbalances, rent-seeking, and regulatory capture.

“Western developed nations subsequently relaxed their strict regulation of the financial sector, and began to shift towards loose regulation and prioritisation of efficiency, implementing financial liberalisation. Former US Federal Reserve Chair Alan Greenspan described it as a case of minimal regulation being the best regulation.

“Following the onset of the 2008 Great Financial Crisis, the fragility of financial systems under light-touch regulation exceeded risk management capability at the microlevel, and regulatory capability at the macro level, which were considered important factors in the onset of this crisis. Financial regulatory theory returned to a dual emphasis upon both safety and efficiency, and the importance of macro prudential measures gradually became commonly accepted, with a renewed understanding of the relationship between central banks and financial stability.

“From the perspective of financial regulatory theory, what kind of financial regulatory system can achieve this dual emphasis on safety and efficiency, which is both strict and flexible, and can effectively balance financial innovation with risk management? I’ll discuss my personal point of view from the following several perspectives.

The relationship between central banks and financial regulation

“The first is that central bank monetary adjustments must be coordinated with financial regulatory policy. From the perspective of modern money creation theory, the central bank money supply is outside money, and money created within the financial system is inside money.

“Monetary adjustments fulfil targets by using outside money to influence inside money, yet regulatory policies are directly applied to financial institutions, with strong authority, rapid guidance, and the force to trigger intense adjustments in inside money, which significantly decide the effectiveness of monetary policy transmission.

“Since April of this year, China has engaged in the concentrated release of financial regulatory policies, which have in reality led to a reduction  in the money multiplier and M2 money supply. It can be seen that although the central bank can adjust outside money, if there is not effective regulation to serve as guarantees, where external money is invested and how efficient it is is beyond the control of the central bank, and it cannot be guaranteed that the financial sector will support the real economy.

“The second is that the central bank’s fulfilment of a financial stabilisation role requires obtaining relevant financial regulation information. Hyman Minsky divided finance into three category – hedge finance, speculative finance and Ponzi firms. Hedge finance refers to relying upon the financing entity’s expected cash revenues to payback interest and principal. Speculative finance refers to the expected cash revenues of the financing entity only being able to cover interest, or being insufficient to cover th principal, and requiring reliance upon roll-over borrowing. Ponzi firms refers to the cash flows of the financing entity covering nothing, and requiring the sale of assets or continuous increases in debt burdens.

“A stable financial system by necessity focuses mainly on hedge finance, and a financial system predicated upon hedge finance will introduce a portion of speculative financing which can raise the efficiency of the financial system.

“In order to maintain financial stability, central banks naturally bear the rescue role of lender of last resort, which out of necessity requires that central banks possess the ability in legal and financial terms to guide the formation of a social financing structure which focuses on hedge finance.

“This ability is out of necessity established on the foundation of the central bank’s understanding of various forms of finance within the financial system, as well as related risk regulatory information. All of which makes it easier to understand the ‘Three Preparations’ emphasised by President Xi Jinping (preparation of important financial institutions and financial holding companies in the financial system, especially those responsible for prudential management; preparation of important regulatory infrastructure, including key payment systems, clearing organisations, and financial asset registration institutions, in order to maintain the stable and effective operation of financial infrastructure, and preparation of comprehensive financial sector statistics, in order to strengthen and improve financial macro controls and maintain financial stability by gathering comprehensive data on the financial sector), as well as the relation between macro prudential management and the central bank.

“Third is that the exercise of lender of last resort functions by the central bank to save the market during crisis requires coordinated financial regulation policies. The lender of last resort role gives the central bank with the key position of being the final line of defence during crisis. As the guide to action for serving as lender of last resort, the Bagehot Rule has been the primary imperative of central banks when it comes to the provision of liquidity ever since the 19th century.

“Because troubled financial institutions are ‘slightly weak and few in number’, and the majority of banks in the financial system might still be in good health, the central bank has neither the responsibility not the need to provide uncompensated assistance to these few banks.

“Thus this rule requires that central banks adopt rapid and decisive action during liquidity crises to prevent the spread of systemic risk, while at the same time abiding by the principle of providing liquidity support to those banks that are experiencing liquidity difficulties but not financial difficulties, in order to prevent moral hazard.

“Institutions facing liquidity difficulties must provide high-quality collateral, as well as pay high rate of punitive interest. If the central bank does not participate in preceding and ongoing regulation, and it is not possible to effectively share regulatory information, it will be very difficult for it to clearly grasp the asset situation of banks, and thus difficulty to make accurate rescue decisions, reducing the efficiency of rescue efforts.

“Regulatory systems require compatible incentives.

“Firstly, regulatory targets must be clear and definite. Noble prize winner Holmstron and his colleague Milgrom in their multitask principal-agent analysis point out that when faced with multiple tasks, agents are motivated to invest all their effort into those tasks whose outcomes are the easier to observe, and reduce or abandon their efforts with respect to other tasks.

“In the sphere of financial regulation, China’s financial regulators often directly bear a developmental role, and under the incentives of the dual regulatory and developmental goals, regulators will naturally be more inclined towards development goals whose effectives are easier to measure, and overlook those regulatory goals whose qualities are difficult to observe.

“From a long-term perspective regulation and development are unitary, meaning that financial system which is stable and highly efficient can also effectively service the real economy.

“However, in the short term regulation and development can potentially see inconsistencies in policy trends and conflicting goals, which leads to the problem of regulators focusing on development, and insufficient regulatory incentives.

“From the perspective of the centre, it’s the bigger the better when it comes to regulatory departments, and with the aggrandisement and development of one’s own sector and operations as an internal motivator, regulatory competition can appear with respect to financial products whose functions are identical and cross-sector business.

“Competition between regulators isn’t necessary a bad thing, and it’s only under the precondition that the same financial product lacks a unified regulatory system that it becomes easy for regulatory competition to transform into rivalry that reduces regulatory standards, leading to a case of ‘bad money driving out good money,’ and by necessity harming the effectiveness of regulation and financial stability.

“If the precondition of a unified regulatory system is satisfied, competition between regulators can become market development competition, or become regulators improving their public services to spur market dynamism and impetus, and benefit the long-term development and stability of the market.

“Secondly, regulatory rights and responsibilities must be commensurate. Economic research determined at an early stage that regulation the sum of regulatory conduct, and that regulators can diverge from the goals of public interest based on consideration of their own personal interests, leading to various malfunctions.

“The first is a supply-demand imbalance in financial regulation. Financial regulation is a public good, but regulators cannot provide public goods based on public interests without costs or hesitation.

“The second is rent seeking in financial regulation. It only takes governments to interfere in resource allocation by means of regulation, for private  parties to seek rent,  thus reducing the efficiency of resource allocation.

“The third is capture of financial regulators, with regulatory bodies potentially controlled by those whom they regulate, and no relationship between regulation and public interest. This is the result of the influence exercise by interest groups.

“For this reason, a regulatory system with mutually compatible incentives must proactively spur prevent regulators from deviating from public interests by means of a rational division of labor and strict accountability, punishment and remuneration systems, and unify the conduct of regulators with respect to overall targets for financial regulation.

“Regulation must effectively balance financial innovation and risk prevention 

“The latest global financial crisis clearly showed that if financial innovation lacks a sound regulatory environment, it’s easy to deviate from the real economy and embark upon a path of blind expansion and growth.

“The pursuit of innovation for innovations sake…after flashing then fading away will not only fail to spur economic growth, but will bring immense disaster for the financial sector and real economy.

“As a key system for supporting the healthy development of financial innovation, financial regulatory should adopt differentiate responses to different forms of financial innovation.

“First is the need for differentiation prudential regulation and non-prudential regulation, and strict implementation of regulatory provisions and bans when it comes to those operations and institutions who were originally subject to non-prudential regulation, and have since engaged in banking operations that should be subject to prudential regulation, as well as those forms of so-called financial innovation that breach regulatory provisions -for example,  P2P lending platforms that in recent years have engaged in fund pooling operations under the name of financial innovation.

“Second is that financial regulators should actively strike against those financial products that are clearly designed to dodge regulation or engage in regulatory arbitrage – for example the financial innovation products of certain financial innovation products that are for the development of direct financing in name, but in practice are actually loan substitute products for directing funds towards restricted sectors or evading macroeconomic controls.

“Third is the application of unified regulator rules in accordance with the principle of functional regulation to those forms of financial innovation that definitely possess innovative value, and whose function types are identical to existing financial operations and products, such as current asset management products.

“The fourth is considering and making reference to international sandbox regulatory trials when it comes to those forms of financial innovation which are temporarily difficult to accurately position. Regulators should raise their level of risk awareness, and cannot only adopt actions after problems arise, but must provide forecasts and have contingency plans.

“The fifth is further refining the regulatory relationship between governments and the market, the centre and regions, in an era when the demarcation between different online financing operations is constantly weakening, to ensure that central regulatory departments and regional regulatory departments engage in highly effective coordination and operation, and guard the baseline against the onset of systemic financial risk.”