Living in Two Worlds: Chinese and U.S. Financial Regulation

Part of Chapter 3 | Financial Regulation

By Douglas J. Elliott1
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China and the United States have been living in two different worlds over the last decade in terms of the direction of financial regulation, and this is likely to continue for some time. One reason this matters is that Chinese banks are playing an increasingly large international role, making it important to coordinate financial regulatory approaches while taking account of differing national conditions. Why has the direction of regulation varied across the two countries? The United States was the epicenter of the global financial crisis (GFC) of 2007–2009. China, for its part, experienced few direct effects, although the indirect ones were large. This contrast in itself triggered differentiated responses, but financial regulation would have varied anyway, given the huge differences in the structure and conditions of the financial sector in the two countries.

The United States entered the GFC with a highly sophisticated financial ecosystem in which banks played an important role, but interacted heavily with nonbanks and markets that collectively provided well over half of the nation’s credit and other financial services. This system used complicated instruments and markets that had developed over decades, including extensive use of derivatives. The pressure testing produced by the crisis highlighted quite a number of flaws in the overall system. As a result, the U.S. response was to enact a wide-ranging set of regulations and laws designed to fix the specific problems and to create a “macroprudential” oversight mechanism to watch out for future systemic risks.

In contrast, China did little to respond directly to what it viewed as a Western crisis that did not reflect any flaws in China’s own financial system. China largely experienced the GFC as an external event with major internal impacts, the biggest of which was a huge drop in foreign demand for its products. The economy slowed noticeably, but primarily in the same ways that it would have been affected by a major world recession triggered by a nonfinancial crisis. China had a considerably less sophisticated and complicated financial ecosystem and made much less use of derivatives and other complex instruments. At the time of the crisis, the great bulk of credit in China was provided by banks through traditional loans. Further, Chinese government entities owned the large majority of the shares of the banks and significantly influenced their overall lending policies.

Effects of the financial crisis on financial regulation

Global standards

Many of the wide-ranging changes the United States introduced were driven by the adoption of new global standards for bank capital and liquidity requirements. The leaders of the G20 countries, dominated by the nations most affected by the crisis, stepped forward to mandate that global standard-setting bodies lead the movement toward stronger and more effective financial regulation within member states. They empowered the Basel Committee on Banking Supervision to revise bank capital standards to be much tougher and to create a new set of quantitative liquidity requirements for banks. They also created the Financial Stability Board (FSB) to oversee standards for all aspects of the financial systems, including coordination with the Basel Committee.

The biggest changes came through the Basel Committee, including: higher minimum capital ratios; tougher definitions of what counts as capital for banks; myriad technical changes that also increased capital requirements; a new liquidity coverage ratio (LCR) to ensure banks could survive a liquidity crisis for 30 days; and a net stable funding ratio (NSFR) to limit the extent to which banks could borrow short term and lend long term. In combination, these rules make banks substantially safer, but also increase their net cost of funding considerably.

China signed onto the changes to global standards, but they have had a relatively limited impact on China’s financial system as it exists today. Capital levels already exceeded the new requirements in general, most of the more technical changes focused on activities that are modest in China, and the new liquidity requirements were geared to be supportive of traditional deposit-based funding models, such as those used by most Chinese banks.

U.S. national regulation

At the national level, Washington also legislated other major changes through the Dodd-Frank Act, covering a wide range of topics, including:

  • Creation of a council of U.S. regulators, the Financial Stability Oversight Council;
  • A mandate to apply “enhanced prudential supervision” to systemically important financial institutions, both banks and nonbanks;
  • Revised rules for dealing with troubled banks;
  • Risk retention rules for mortgage securitizations;
  • Tougher mortgage underwriting standards;
  • Toughened requirements for credit-rating agencies;
  • Establishment of a new Consumer Financial Protection Bureau (CFPB);
  • Limitations on the ability of the Federal Reserve to lend in a crisis; and
  • Tougher limits on credit exposure to a single counterparty.

Chinese national regulation

The Chinese response was different. Prior to the GFC, China had been moving methodically toward building a financial system that mimicked a Western model that appeared to be highly successful. The crisis caused a sharp reevaluation of the value of the Western approaches. Further, the Chinese government chose to use bank lending as the major form of economic stimulus postcrisis. While Western regulators were implicitly and explicitly encouraging greater caution about credit risk in their countries, China was actively encouraging their banks to find ways to get to “yes” on loan approvals.

Even if the Chinese had been minded to closely follow the new Western approach to tightening regulation, large swathes of these new regulations were almost irrelevant to a Chinese financial system that simply did not use the type of sophisticated instruments and approaches that had blown up in the United States and Europe. For example, changes to derivatives regulations and the supervision of rating agencies would have made little difference in the short term to a Chinese system that did not rely heavily on either.

Instead, China focused on further developing its financial system and continuing the move toward more commercial decisions and less intervention by the government and Communist Party. At the same time, the creation of new commercial opportunities also brought new risks, such as from “shadow banking,” which have required new regulations and more nimble supervision. For example, banks began to take advantage of the regulatory arbitrage offered by the opportunity to sell “wealth management products” (WMP) that effectively took loans off balance sheet while funding them relatively cheaply, since investors almost universally assumed that no bank would be allowed to default on the promised returns. Regulators have taken a series of actions to limit this regulatory arbitrage, but clever actors have found new ways to do versions of the same thing, such as switching initially from using bank WMPs to trust company WMPs and then to equivalents offered by funds managers.

Internet-based lending is another area that brings both real opportunities and risks. China has seen a massive level of experimentation by the private sector, and it is crucial that regulators keep pace with these developments.

The future of financial regulation in the United States and China

The United States is engaged in a major reevaluation of the costs and benefits of the massive wave of regulation produced after the GFC. The new administration clearly believes these must be recalibrated to cut the costs that have been imposed on banks, and ultimately the larger economy, while retaining the core safety benefits. Despite the rhetoric, such as the call to “repeal Dodd-Frank,” the large majority of postcrisis regulation appears likely to survive. There will be important changes, including elimination or considerable loosening of some regulations, but the overall approach is likely to stay intact.

China faces a different set of issues, revolving around different risks. Accurately determining the level of bad loans in the system and ensuring they do not endanger the system as a whole will be a major emphasis for regulators. This will require continuing efforts to thwart regulatory arbitrage, cut back on restructuring of loan terms that defer problems without solving them, and the gaming of definitions, as well as applying tough supervision more generally. Transparency will also be critical, so that all stakeholders can be confident of the accuracy of balance sheets.

On a more hopeful note, China’s financial system continues to mature, with market-based financing becoming more important. Institutional investors are growing in influence and sophistication, which is essential for the appropriate development of financial markets. Beyond these two points, there are many other challenges and opportunities for China’s regulators as the country’s financial system changes in ways that mirror the rise of the country as a whole and the growth of its private sector and its markets.

Interactions between the United States and China on financial regulation

China presents a unique situation for global financial regulators. It is the first time in recent history that banks from an emerging market nation are becoming major international lenders. This presents a quandary. Since the creation of the first Basel capital accord in 1988, regulators in the major financial centers have attempted to maintain a safe global system and a reasonable competitive balance by ensuring that the big international lenders face similar cost burdens from capital requirements and, later, liquidity requirements. After the GFC, these capital and liquidity standards became even more detailed and tougher. As such, it is important that the requirements be appropriate for the jurisdictions of all the major international lenders. This works reasonably well for North America, Europe, Japan, and most other advanced economies around the world, because they have similar enough systems.

However, China is different and is likely to remain so for years to come. The right regulatory environment for a country whose economy and financial system are still rapidly evolving, and where there is substantial state control through share ownership and other mechanisms, will differ from that for the existing major financial centers. Balancing the need for a level global playing field in a safe global financial system with the specific needs of China will be important and difficult.

The other area of interaction between the United States and China is in regard to American banks operating in China. The government and regulatory community in China explicitly agree that international banks should be able to compete with local players. And, yet, foreign market share in banking has remained at about 2 percent for many years, despite a strong appetite for expansion.

Recommendations

U.S. and Chinese regulators are appropriately focused on quite different issues today and will, and should, remain that way for years to come. Washington is in the process of digesting the massive postcrisis regulatory changes and searching for appropriate cost/benefit tradeoffs between safety and economic growth. Beijing is focused on the combination of the many challenges and opportunities presented by a growing and evolving financial sector, alongside current issues of excessive bad loans.

At the same time, both countries and the larger global community need to find a way to allow Chinese banks to expand to be among the largest international lenders without creating incentives for taking excessive risk. This will require sorting out what parts of the global standards truly need global application to large banks that lend overseas, what parts can be tailored to specific national circumstances and to what extent, and what parts really only apply well to banks in the West or with similar systems.

In theory, the Basel Committee and the FSB have already done this. However, it is clear that emerging countries have had too little influence on global standards. This is partly because the West felt a far more urgent need for the new standards, partly because emerging nations have not stepped up to the extent they ought to, but also in quite substantial part because the West is used to running these committees and has not reached out sufficiently for input. For example, the LCR and NSFR rely on a definition of “high-quality liquid assets” (HQLA) that was too closely tailored to Western institutions and markets. This was brought to the attention of the Basel Committee relatively early on, but only modest efforts were made to provide alternative methods for defining or creating HQLA.

The United States and other Western nations need to make a more active effort, in their national discussions with China and in global bodies, to understand and accept the genuine needs of China. They need to be willing to accept approaches that achieve the common purposes in a manner better suited to China.

At the same time, China needs to fully recognize the value of the global standard setters and to work harder to push for global approaches that work for all the major global lenders. This includes truly accepting the need to eventually adopt those standards. Right now, there is some suspicion that China has played a less active role because it views the standards as advisory and not truly a common statement of shared principles. Despite the differences in conditions, many of the global reforms are appropriate for China as well and local regulators would benefit from putting them in place.

It would also be helpful to both nations if Chinese authorities made more of an effort to find ways to overcome the many structural barriers to foreign expansion in Chinese banking markets. Many of these are not the result of government policy, rather they reflect existing relationships and practices that are difficult for foreigners to compete against. However, the benefits for China as a whole make it worthwhile for regulators to more actively work against these barriers. Such a move would also reduce frustrations that might lead other countries to be less open to Chinese banking operations.

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[1] The author is a partner at the management consulting firm of Oliver Wyman. The views expressed here are his own and do not necessarily reflect the views of his firm or his partners.