The Tide of Reform and China's Financial Regulatory System

After the U.S. subprime mortgage crisis,central banks were given increasing importance in financial regulation as we can see from regulatory reforms in the world's major economies such as the U.S.,the U.K.,Europe and Japan. Regulation has shifted to a macro prudential focus,with an aim of preventing systemic crises,maintaining sound development of systemically important financial institutions (SIFIs) and protecting consumer rights and interests. China is maintaining its regulatory structure of "one bank and three commissions" - or the central bank and regulatory commissions for banking,securities and insurance. With a wave of macro-prudential regulatory changes around the globe,what does China plan for its reforms in financial regulation? 

Zhong Wei,deputy editor-in-chief of China Forex Magazine,speaks to Xu Gao,chief economist at Everbright Securities,and Zheng Liansheng,associate researcher from the Financial Institution of the Chinese Academy of Social Sciences.

Zhong Wei: Prudential financial regulations consist of both macro regulations focusing on preventing systemic risks and stabilizing the market,and micro regulations aiming to control capital adequacy ratios and overall risks. People tend to think that it is the central bank's duty to take macro prudential measures,while the financial regulatory agencies should be responsible for micro regulatory matters. However,financial regulations in major economies have changed a lot since the subprime crisis and the European debt crisis. Does this suggest there is friction between traditional macro and micro prudential regulations?

Xu Gao: One major cause of the subprime crisis was the expanding gap between macro and micro prudential regulations. Macro regulators can hardly detect changes in micro areas while micro regulators are often incapable of spotting macro risks. This reduces regulatory efficiency.

In recent years,the transfer of risk within the financial system is much faster than before as the system has become more complex thanks to innovation,market liberalization and universal banking. Therefore,theorem-based micro prudential regulations by a single financial institution face considerable challenges. For example,a certain financial institution might be holding multiple positions exposed to risks whose sources,under normal conditions,have little connection with each other. Even if a problem arises,a weak capital buffer could be enough to maintain stability. But under abnormal conditions,the same risks could affect other parts of the financial system in a short period of time,and micro prudential regulation alone might not be sufficient.

In addition,the stability of some major financial institutions is directly related to the health and stability of the whole financial system. For this reason,if the macro prudential regulators fail to gain a clear picture of the actual condition of commercial financial institutions,they may be unable to detect risks early enough. That would mean that regulatory policies already in place might not be as effective as regulators anticipated.  Therefore,we should coordinate macro and micro prudential regulations to build a comprehensive financial regulatory system.

Zheng Liansheng: The relations between macro and micro prudential regulations and between central banks and the financial regulatory institutions continue to change. In the latter half of the 1990s,the functions of setting monetary policy and stabilizing the financial system began to develop along separate paths. Independent regulatory institutions were established by the U.K.,Japan and some Northern European countries. In the U.K.,the Financial Services Authority was founded to maintain financial stability,and this weakened the role of the Bank of England in preventing systemic risk and maintaining financial stability. After the outbreak of the subprime crisis,the U.K. encountered the first bank run since 1866. After reflecting on its regulatory structure,the British government concluded that maintaining financial stability was the fundamental duty of the central bank,and it restructured its regulatory system accordingly to allow the Bank of England to carry out macro prudential regulations that focus on systemic risk. Other major developed economies like the U.S. and the EU also reformed their regulatory systems after the crisis. It has become a trend that the central banks hold the macro prudential responsibilities and the financial regulatory institutions perform micro regulatory duties.

The relations between macro and micro prudential regulations indeed reflect some internal problems. One is related to the exchange of information. Regulatory institutions may filter out some unfavorable data before delivering information to the central bank. They may also lack a clear enough picture of inter-departmental and inter-market position risks or the means by which these risks spread. The second problem is in making a coordinated response to problems,as we can see from the case of the Northern Rock bank crisis in the U.K. The third problem concerns regulatory gaps. Due to the occasional divergence of regulations,some businesses fall into a grey area or even a regulatory blind spot. These areas can include shadow banking,Internet finance,hedge funds,credit enhancement and the securitization of complex assets.

Zhong Wei: Despite the great pressure from the subprime crisis,criticism of the "Greenspan Bubble," and disputes over continued quantitative easing,the Federal Reserve System still maintains its dominant role in financial regulation,including regulation of financial holding companies and SIFIs,the monitoring of the market,payment clearing and asset prices,improvement of financial crisis bailout and liquidation bankruptcy mechanisms,and stresses from systemic risks. Why do you think the subprime crisis didn＊t weaken the Federal Reserve's role in macro prudential regulation but instead strengthened it? 

Xu Gao: The strengthened role of the Federal Reserve in macro prudential regulation is a result of development of the financial system. No matter what we might think of the monetary policies of the Federal Reserve in the past,we must acknowledge two things. On one hand,the spreading of risk within the financial system had become much easier. On the other hand,the market and the economy as a whole had been shored up by liquidity from several rounds of quantitative easing. The monetary policies of the Federal Reserve had turned into pillars of strength that maintained the stability of the whole financial system. Thus,there is no doubt that the Federal Reserve has taken on a greater role in macroprudential regulation. The Federal Reserve has unique advantages in curbing the spread of internal risks to the entire financial system. It has to address areas of instability by using monetary policies and at the same time examining possible instabilities induced by the use of its policies. Central banks of all countries have thus become the crucial "watchdogs" for the prevention of financial risks.  

Zheng Liansheng: The mismatch of a sector-based regulatory system and the universal banking model of financial institutions were seen as the root cause of the financial crisis,while the faults of the Federal Reserve were merely the result of technical problems.

After the reform of the American regulatory system,the Federal Reserve turned into a "super regulator" and financial stability became its third policy goal. Here are five reasons why the Federal Reserve has taken on such a critical role in macro prudential regulation:

First of all,its enhanced role is a matter of structure. The newly established Financial Stability Oversight Council is the supreme coordinator for systemic risks,but it has no executive arm or branches. As a result,the Federal Reserve has become the council's "agency." Second,the Federal Reserve is the entity with responsibility. The U.S. has a sector-based regulatory system,but systemic risks require cross-sector measures. Only the Federal Reserve is capable of cross-sector regulation and risk response. Because of this,the Federal Reserve is the most appropriate vehicle for macro prudential regulation. Third is its credibility with the public. The Federal Reserve has maintained its independence and a high level of public credibility for a long time. It has taken appropriate measures such as carrying out the management of expectations,launching a "communication revolution" and issuing policies during and after the subprime crisis. Fourth,it had the capacity to cope with systemic risks. The outbreak of the subprime crisis demonstrated that liquidity,SIFIs,shadow banking and financial infrastructure all were sources of systemic risk. The Federal Reserve was the right vehicle to address those risks due to its advantages in information collection,its regulatory tools,and its credibility with the public. That gave it the capacity to control the overall situation. Fifth,it had the necessary experience. The bankruptcy of Lehman Brothers caused the money market to freeze up as liquidity evaporated. Ultimately,it was the Federal Reserve that had to step in to resolve the liquidity crisis. The above five factors prove that the America