Nicolas Véron

Korea Herald column (April): Latest financial supervisory reform diverts China from the path towards a market-based financial system

This column was published in The Korea Herald six months ago, my first column for that newspaper. I had omitted to repost it on this website at the time.

In May last year, China inaugurated a new system of financial sector supervision, which had been announced two months earlier during the twin plenary sessions of the National People‘s Congress and Chinese People’s Political Consultative Conference. One year on, it is time to take stock. Sadly, all indications suggest that the supervisory overhaul will make it more difficult, rather than easier, for China to make progress in the direction of a market-based financial system that could efficiently allocate capital in its increasingly large and complex economy.

The reform has two main components. First, the former China Banking and Insurance Regulatory Commission, renamed National Financial Regulatory Administration (NFRA), got an expanded supervisory mandate covering the entire scope of financial firms in China except stock exchanges and securities firms that remain under the China Securities Regulatory Commission (CSRC). The NFRA‘s role includes financial customer protection and the supervision of financial holding companies, previously carried out by the People’s Bank of China (PBC), as well as investor protection duties transferred from the CSRC. As a partial offset, the CSRC received bond market oversight responsibilities previously held by the National Development and Reform Commission in a belated legacy of the days of top-down “credit planning” before the market-oriented reforms of the 1980s and 1990s. Correlatively, the NFRA took over the bulk of the supervisory capacity previously under the PBC, namely more than 1,600 county-level branches according to a Financial Times report. As China‘s central bank, the PBC retains responsibility for macroprudential oversight, but it has essentially lost its once all-encompassing role as financial supervisor, a process that had started in 1992 when the CSRC was spun off from the PBC.

Second, a new structure is overlaid above the NFRA in the form of the Central Financial Commission (CFC) which is given a general role of oversight of the financial sector, replacing a lighter Financial Stability and Development Committee that had been set up in 2017 but never quite found a role. Unlike the NFRA, which like the CSRC and PBC formally reports to China‘s State Council, the CFC is a body of the Chinese Communist Party. It is also a substantial central agency, not just a small coordination office, with significant specialized personnel and a permanent office close to those of the NFRA, CSRC and PBC in Beijing’s “Financial Street” neighborhood. Veteran officials with experience of state-owned bank management have been appointed to head the two bodies, namely Li Yunze for the NFRA and Wang Jiang for the CFC, the latter formally as deputy to He Lifeng, China‘s economic affairs Vice Premier who doubles as Director of the CFC’s Office. Meanwhile Wu Qing, another politically savvy official with financial experience, was appointed in February as the new head of the CSRC.

As so often in China, the authorities gave no clear explanation of their motivations underpinning these major changes. There were no discussion papers, no public hearings, no observable debates. In fact, the semblance of policy deliberation that had accompanied previous changes in that space was not only abandoned, but even ironically inverted. Previous major changes in the financial sector policy framework had been preceded by a “national financial work conference” that set the stage for forthcoming reforms and were at least a performative expression of deliberative process. These conferences had regularly occurred every five years since the first one in 1997, which paved the ground for China‘s first major state-directed financial sector restructuring. On that established basis, a financial work conference should have been held in 2022, but the year came and went with no announcement. Instead, the new supervisory structure was publicized seemingly out of the blue in March 2023, and the new bodies promptly inaugurated in May. Only in November 2023 was a “central financial work conference” held in Beijing ― ostensibly a formality, with the adjective “central” replacing “national” as a clear indication of the shift from state to party emphasis.

At the time of the initial announcement last year, some analysts attempted to rationalize the reform by portraying it as what financial supervisory experts refer to as a “twin peaks” architecture. The twin-peaks concept was coined in the 1990s and adopted since then by countries including Australia, Belgium, the Netherlands, South Africa, and the United Kingdom (UK). As its name suggests, it entails a division of labor between two main financial regulatory authorities: one in charge of prudential supervision, working against systemic risk, and the other in charge of conduct-of-business supervision, defending market participants against abuses of information asymmetries and fraud and ensuring market integrity. In the UK, for example, the names of the two authorities directly reflect their respective mandates, namely the Prudential Regulation Authority (which is part of the Bank of England) and the Financial Conduct Authority. But the new Chinese architecture clearly does not conform to the Twin Peaks template. The NFRA cumulates both mandates, prudential and conduct-of-business, while the CSRC is left with a diminished scope of conduct supervision compared with its pre-reform status.

On the face of it, the new Chinese framework is functionally comparable to that adopted in Korea in the late 1990s, which entails a sector-wide Financial Services Commission making policy and the Financial Supervisory Service implementing it, echoing the respective roles of the CFC and NFRA. But the cost-benefit balance of an all-encompassing sector-wide supervisor is very different in a massive financial sector like China‘s, the world’s second-largest by most measures (or even first, e.g. by size of banking assets ― see chart), versus a medium-sized one like Korea‘s, where it makes more sense to centralize all policy mandates in a single institution. In that respect, the CFC/NFRA architecture rather resembles that adopted by the UK also in the late 1990s, with an all-powerful Financial Services Authority (FSA) supervising all financial firms and markets. Even though the UK financial sector at the time was considerably smaller than China’s now, this setup turned out to be too unwieldy and ended in disastrous failure with the great financial crisis of 2007-2009, after which the UK switched to the Twin Peaks concept. The UK FSA tried to exercise all financial supervisory mandates at once, and ultimately failed to deliver on them simultaneously, with particularly unforgiveable lapses of its prudential duties leading to the costly collapse of Royal Bank of Scotland and other major British lenders. This definitely does not look like the right template for China to emulate.

Rather than a more effective or efficient allocation of supervisory roles, the real motivation of China‘s reform appears all too obvious: a blunt reassertion of Communist Party control. This is, of course, embodied in the NFRA’s evident subordinate status to the Party-labeled CFC, and also to the parallel revival of a Central Financial Work Commission whose proclaimed task is “to strengthen the ideological and political role of the Party in China‘s financial system”. This may be related to a perception of mounting risk in China’s financial system, with particularly alarming developments in the property market and local government financing, or simply with a general tendency towards reinforcing the “vertical of power” in Xi Jinping‘s third term. Be that as it may, the appearance of a demotion of supervisory independence and expertise is reinforced by the steep pay cut imposed on NFRA and PBC staff, and by the sidelining of the PBC which had perhaps come closest to an autonomous, technocratically driven institution within the hyper-politicized Chinese system. Indeed, the upshot of this reform may be simply that under the present circumstances, the Chinese party-state can simply not countenance anything that might resemble an independent administrative body.

But there lies precisely the challenge for China. Public bodies with well-defined mandates and authority to act independently, including central banks and financial supervisors, are critical to the operation of complex market-based financial systems. Formally, China dismantled its centrally-planned credit system during the two decades between 1978 and 1998, but old habits die hard. The shareholding structure of the dominant Chinese commercial banks, brokerages and institutional investors makes them state-owned or state-controlled. Experiments to introduce more private ownership in the financial sector since the 1990s have largely failed, as too many of the new entrants turned out to abuse their customers or be outright frauds. The predecessors of today‘s CFC and NFRA were never fully capable of properly policing a complex market-based financial system. The present structures appear even less prepared to become effective supervisors of decentralized, market-based actors. To be sure, financial supervisors everywhere are ultimately accountable to political authorities, but the best ones are sufficiently insulated from direct political interference to create a favorable environment for market activities. Even Napoleon, who was not driven to relinquishing control, memorably stated in 1806 after creating the Bank of France that he “want[ed] that the Bank be sufficiently in the hands of the government, but not too much so”. The Chinese Communist Party seems to know no such restraint these days.

The long-term impact of the complex changes brought last year to China‘s financial supervisory system remains to be seen. The new structure has barely been put in place and has not yet been tested in crisis. But the omens are not good. By sidelining its central bank, creating an all-encompassing supervisory behemoth, and placing it under the pernickety oversight of a top-heavy Party commission, it is likely that China has structurally degraded the effectiveness of its financial supervision.

Korea Herald column: Relaxing capital requirements would plant the seeds of the next banking crisis

This article was published in Korean by The Korea Herald newspaper on 25 October. It is also available, together with the version in Korean, on The Korea Herald website.

Banking regulation goes in cycles that are punctuated by crises. Typically, a crisis results in regulatory tightening. Then after an extended period of time, memories of the crisis fade away, and policymakers end up yielding to bank lobbyists‘ constant push for loosen the rules. Then banks take more risk as allowed by the weaker new rules, and more often than not, a banking crisis erupts. Then everyone asks why nobody saw it coming.

There is a paradox at play here. Demanding and well-enforced capital requirements actually tend to benefit the banking sector as a whole, as they buttress confidence in the entire system. Even so, however, at least in countries where banks are mostly joint-stock companies owned by private shareholders, bank lobbyists always ask for relaxing the rules, irrespective of the circumstances. In the short term, such lobbying is rational. All things equal, more leverage allows the banks to increase their return on equity and thus to give greater immediate satisfaction to their shareholders and, in most cases given the structure of their compensation incentives, to increase the bankers‘ own remuneration. But in so doing, bankers don’t lobby in their employers‘ long-term interest. (Of course, there could theoretically be such a thing as excessive capital requirements, but analysts who are not somehow beholden to the banks near-unanimously concur that the current levels are far from that mark.)

This cycle has been observed time and again. The great financial crises of the 1930s in Europe and America (the 1920s in Japan) led to a tightening of prudential frameworks that ensured widespread financial stability until the 1970s. From then, a deregulatory cycle started that brought increasingly frequent crises, including that of 1997 in Korea and the major financial crisis of the late 2000s in Europe and the United States which saw the collapse of major institutions such as Bear Stearns and Lehman Brothers in America, Royal Bank of Scotland in the United Kingdom, or Westdeutsche Landesbank in Germany. In response, a new consensus on tighter requirements formed among the world‘s prudential authorities assembled in the Basel Committee on Banking Supervision, which meets regularly in the Swiss city of Basel. The result was a set of rules collectively known as Basel III, issued by the Basel Committee in several batches, the first in late 2010 and the last, nicknamed the Basel III Endgame, in late 2017.

Since the climax of the great North Atlantic crisis only happened 16 years ago in 2008, one would expect that the memories thereof are still fresh enough to avoid a harmful swing of the pendulum in the deregulatory direction. Deplorably, that expectation would be wrong. The indications are multiplying that policymakers are rapidly forgetting the painful lessons that were inflicted on them or their predecessors less than a generation ago.

In the United States, Federal Reserve Vice Chair Michael Barr announced in September that the standards to implement the Basel III Endgame would end up being significantly less strict than earlier proposed. Even though the detailed text has not been published, this announcement has been widely understood as a lack of capacity of the U.S. prudential authorities to resist fierce bank lobbying, in the country‘s present context of extreme political polarization.

The European Union, whose banks collectively hold even more assets than those in the U.S., has recently adopted legislation that is far from fully compliant with Basel III. Even so, there are calls to water it down further. No less an authoritative figure than Mario Draghi, the former president of the European Central Bank, wrote in a recent report that the EU should “assess whether current prudential regulation, also in light of the possible upcoming implementation of Basel III, is adequate to have a strong and international competitive banking system in the EU”. In late September, the heads of the Treasury Departments of France, Germany and Italy have sent a joint letter to the European Commission in which they call for putting “stronger emphasis on the competitiveness of the financial sector, particularly banking, and its capacity to finance the economy”. In both cases, the reference to competitiveness of the banking sector has been understood by commentators as a call to relax capital requirements.

In line with the above-mentioned paradox, the largest U.S. banks are in a much stronger competitive position than their European counterparts ― as Draghi acknowledged in his report ― after a decade during which they were subject to generally higher capital requirements. The latest assessments by the Basel Committee, issued in 2014, had found the U.S. “largely compliant” with the first batch of Basel III rules, while the EU was “materially non-compliant”. (Korea was deemed largely compliant in 2016.) A tweak is that the EU imposes its version of Basel standards on all banks irrespective of size, whereas the U.S. does so only on the very largest. (The Basel Committee only says that its rules are intended for large internationally active banks, without setting quantitative thresholds to define the category.) Predictably, this creates financial stability vulnerability among medium-sized U.S. banks, as the short but highly unfortunate crisis around Silicon Valley Bank and peers disastrously illustrated last year. But local banks are so politically influential in the U.S. that prudential authorities have never been able to expand the scope of Basel application even to banks with total assets well above a hundred billion dollars.

For the European Union, the non-compliance with Basel III is particularly embarrassing. It is overrepresented in the membership of the Basel Committee, which includes no fewer than eight EU countries (Belgium, France, Germany, Italy, Luxembourg, the Netherlands, Spain and Sweden) as well as the EU itself among its 28 member jurisdictions. Of these, seven (all but Sweden) are part of the euro area and thus of the banking union, a framework that has now been in place for a decade and implies that individual euro-area countries no longer have an independent supervisory policy. Furthermore, the EU describes itself as uniquely committed to global standards and the international rules-based economic and financial order. In such a context, the combination of such stark overrepresentation with poor compliance is galling.

In the United States, the adherence to that order is at risk of being further weakened in the years to come, depending of course on the outcome of the forthcoming presidential election. But at the end of the day, jurisdictions such as the U.S. and the EU should not just adhere to Basel standards for the sake of robust global governance. They should do so out of a lucid but also narrow definition of their own self-interest, namely avoiding the devastation of future banking crises. For that, the U.S. should expand the scope of application of Basel III to its medium-sized banks, and the EU should move towards full compliance. Sadly, in the near future at least, there is scarce chance of either doing so.

Joint opinion article with Joachim Nagel: Breaking the vicious circle between banks and sovereigns for good

On Tuesday 22 October, Politico published an opinion article coauthored with Joachim Nagel, in which we advocate completion of the banking union and outline what it would involve. 

Study for the European Parliament: Banking union and the long wait for cross-border integration

In this study published by the European Parliament last Friday, my Bruegel colleagues Giulia Gotti, Conor McCaffrey and I document the continued fragmented condition of the euro-area banking system despite a decade of implementation of the (admittedly incomplete) banking union framework. This study provides an empirical complement to my recent book on Europe's banking union. 

Financial Statements: A holistic perspective on climate and financial policies

In this week's session, I hosted Pierre Wunsch of the National Bank of Belgium and Irene Monasterolo of University of Utrecht, for a spirited conversation on the consistency of the EU's climate and financial regulatory policies.