The Need for Vigilance in the Face of Liquidity Risks
Regulators from different government agencies have rolled out a series of policy directives aimed at reducing financial risk，curbing irregularities and ensuring that financial institutions are serving the real economy. The provisions of these documents are unprecedented in terms of scope and strictness. But these regulatory efforts，ambitious as they are，should not give rise to a false sense of confidence. The financial system still faces potential liquidity risks as regulators try to reduce leveraging in the world's second largest economy，and there is a need for further vigilance.
The People's Bank of China is one of the regulators that has set its sights on lowering financial risk and reducing the degree of leveraging in the economy. In 2016，it unveiled an updated version of its Macro Prudential Assessment (MPA). The central bank also included off-balance-sheet wealth management products in the first quarter of 2017.
The MPA is quite rigorous and banking institutions have treated the assessment with even greater care than in the past. Some institutions have been struggling to reach the regulatory goals，but the framework rules are clear and simple.
The actions of the central bank will not inadvertently create new risks within the financial system. But other policy initiatives，along with the PBOC's prudent and neutral monetary policy，may have unintended consequences. Consider the combined effect of some of these other measures: Since late March，the China Banking Regulatory Commission has encouraged banks to conduct "self-examinations" to address irregular practices，the China Insurance Regulatory Commission has implemented a special examination project aimed at reducing risks in the use of capital，and the China Securities Regulatory Commission has tried to tackle problems with the asset management operations of securities companies，looking at capital adequacy and putting in place new qualification requirements on financial products.
Moreover，the Shanghai and Shenzhen exchanges have imposed new net worth requirements for individuals trading on the exchange bond markets and limiting their participation to top-rated debt.
Taken together，the result could be tighter liquidity and even dramatic changes in asset prices.
The People's Bank of China is concerned about the tight liquidity conditions on the interbank money market and it has taken fresh steps to insure that the market operates smoothly.
Without doubt，market participants have a strong belief in the ability of monetary authorities to coordinate market supervision and respond quickly to any potential crisis. The risk of events slipping out of control is minimal，but policy makers as well as investors need to be alert to market developments.
Quantifying the Risks
Liquidity risk has long been viewed as the chief threat to the financial system. During the 2008 financial crisis，many large financial institutions were brought to their knees by the sudden loss of liquidity as troubled institutions were unable to obtain needed funds from the market. In severe circumstances an entire market can be paralyzed by the impulse of investors to protect their capital. That drains the entire market of liquidity. Consequently，the financial crisis worsens and produces an economic crisis. During the 2008 financial crisis，the US bond and money markets were most vulnerable to this kind of shock and the European debt crisis，which soon followed，repeated this pattern.
In terms of China's financial market，liquidity issues have arisen many times，but in each case so far there has been a resolution before more serious damage could be inflicted on market participants. The most dramatic cases were the cash crunch in June 2013 and the liquidity shortage in December 2016 when the capital chain of some financial institutions was on the edge of breaking. Less drastic liquidity problems emerged at the end of 2010，in mid-2011 and in early 2015.
There has been a short breathing space since the latest round of liquidity problems in December 2016，but real stability has not yet returned to the market. Interest rates on the money market remain high and are still rising. And there are a number of market abnormalities.
To begin with，the rate of return on wealth management products issued by the four largest state-owned banks used to be the lowest in the market. However，rates have increased to levels above market average，and this is quite unusual. This shows that liquidity shortages in the banking sector are a problem felt across the entire market.
Banks have also issued large amounts of negotiable certificates of deposit (NCDs) and the average yield has reached almost 5%，the highest level since the second quarter of 2015. Furthermore，NCD rates have been lower than those of wealth management products for most of the time since the second half of 2013 when NCDs were first issued. In contrast，NCD rates have climbed to levels above those of wealth management products，showing strong demand from banks for funds. This is particularly true for joint-equity commercial banks and small and medium sized financial institutions.
Compared with deposit-taking financial institutions，non-deposit-taking financial institutions，which have less access to funds available in the market，are facing even higher costs. As of the end of March，the pledged repo rate of non-deposit-taking financial institutions in the interbank market reached 4.88%，206 basis points higher than the rate for deposit-taking financial institutions. As non-deposit-taking financial institutions account for about 30% of the 4 trillion yuan total of repo financing，the structural problem is severe.
Against this background，once signs of a market disturbance appear，liquidity risks are likely to rise. Some other factors may also lead to a heightened liquidity risk:
The first factor is the large volume of bonds. The volume of outstanding bonds has doubled to over 60 trillion yuan over a period of just three years. Bond trading volume has increased from 40 trillion yuan to 120 trillion yuan，and the total financing volume from the money market has climbed to 800 trillion yuan from 230 trillion yuan，with overnight funds accounting for the majority.
The second factor refers to the complicated investor structure and investing pattern. Different financial parties are closely related to each other. Banks' total assets over total deposits ¨C or assets not supported by deposits ¨C have risen by 30% in the last three years. Debt of non-banking financial institutions owed to banks has increased to 27 trillion yuan from less than 10 trillion，a reflection of the close relationship between the two types of institutions. Off-balance-sheet assets of banks now total about 100 trillion yuan. At the same time，total assets under management in the domestic market are also around 100 trillion yuan，with a high degree of interconnection among financial institutions and financial products.
Policy Recommendations
The first policy suggestion is for authorities to maintain their prudent and neutral monetary stance and control the rapid expansion of credit. An obvious problem in China is that a combination of a high degree of leverage，a low level of financial efficiency and rapid credit expansion does not lead to productive economic growth. Rather，it induces capital to flow to speculative areas of the financial system，in turn driving up leverage ratios in the economy. This creates difficulties in sustaining real economic growth.
The second recommendation is to cut unnecessary links among financial institutions，control the scale of banks¡¯ off-balance-sheet operations and tighten regulation of the asset management business. Raising the financial requirements and risk control standards for market participants is necessary to encourage sustainable business patterns while there is also a need to decrease the leverage ratio in the bond market.
The market also needs to be less dependent on the central bank for liquidity. The banking system should re-establish the function of supplying liquidity to the market，otherwise the system will become highly vulnerable. The banking system has lost its safety cushion due to its rapid expansion of assets，highlighted by the fact that banks are unable to provide enough qualifying collateral when the central bank attempts to inject liquidity into the market.
The process of deleveraging should also proceed in an orderly manner in order to ensure stable market expectations. Currently，there are three key shortcomings: firstly，banks use the issuance of NCDs as an important financing channel，but there are issuing difficulties and rates are too high. At the same time，the market is having difficulties in absorbing the 30 trillion yuan in wealth management products at present. And lastly，financing costs for non-deposit-taking financial institutions are still too high.
The deleveraging process will definitely result in a heavier burden on the liability side and greater volatility on the asset side. It is also important to clarify priorities and avoid intensifying structural conflicts and potential risks.
The author is managing director at CITIC Securities