There is a fundamental difference between the way in which China regulates its securities market and the way many Western markets are regulated. 

This difference is most observable in the basic functions of the Chinese Securities Regulatory Commission (CSRC) and the Securities and Exchange Commission (SEC). 

The SEC is focused on ensuring compliance to regulations, the CSRC “balances” two responsibilities, ensuring compliance and encouraging growth/development. 

Is this arraignment a classic case of the wolf guarding the chicken coop?

The CSRC is the door keeper to the market, they issue licenses to different types of financial service firms. 

Usually, these are short term, for a year, and the CSRC can control market access and, in effect, regulate the market by controlling these licenses. 

The question that comes into play is how does the CSRC monitor itself internally to ensure that these licenses are issued in way to encourages growth of the overall market and that opportunities for self enrichment are controlled? 

Next week we will discuss some of the recent history in regards to State Owned Enterprises (SOE) and the trouble they have had in reform.

Companies may apply for China Banking Regulatory Commission (CBRC) approval to engage in insurance or securities activities.

It then becomes the regulatory commission’s duty to oversee and inform the companies as to what ways their subsidiaries are allowed to cooperate, and in what ways they must remain separate.

Chinese banks are pushing the commission for a more universal banking regulatory framework, which is enticing because of all of the business growth opportunities it offers for the developing Chinese Financial market.

With international banks pursuing entry to the Chinese financial services market the CBRC will have the increasingly difficult task of developing regulation.

The CBRC must ensure that the Chinese financial market matures and develops while nurturing a young sector of China’s national economy to compete with mature international competition.

The fastest way to develop the financial market is for local Chinese banks to look for international talent and there isn’t much to slow local banks from hiring western talent, after the massive job losses western banks and financial service sectors.

Many have blamed the shortcomings of Western banks on overzealous greed, and lack of regulation in keeping the banking sector apart from the capital markets.

This accusation very well may be true, and the Chinese financial system should benefit greatly from looking at and analyzing, the cause of the Western banking system’s collapse.

The heavy regulations that led to the slow development of these separated Chinese banking, insurance and securities markets has greatly insulated them from the problems that currently face Western financial firms.

While I believe that this was due more to lucky timing, as opposed to prudent planning, the Chinese financial system appears to be poised to take a leadership role this century.

While the Chinese financial firms were straining to be released from the CBRC heavy regulation, as the early 2009 Citigroup restructuring shows us, this so-called ”universal banking” might not be the perfect solution that it was once touted to be.

There must be some balance between the financial service firms having the freedom to pursue profit and growth, and government efforts to monitor and regulate their activities.

As the western financial meltdown has revealed, massive profits are not necessarily an indication of the health of a business, especially a business that is so entwined with so many nations’ economic stability.

While Chinese banks dream of making the profits their Western counterparts did for some many years, the Chinese market will be much less responsive to the sophisticated financial products offered in the West.

 The Chinese are much less willing to take financial risks, especially now that the weaknesses of the Western banking system have been exposed.

While the last year of financial turmoil has cooled the drive to deregulate the strict divisions placed on the services that Chinese banks and financial institutions have been about to offer.

The first steps towards a “financial supermarket” of services came from a small tweak in the restrictions in 2000 and 2001, a significant change occurred in 2002 with the establishment on China Unionpay. 

Both the state council and the PBOC approved this new company even though the business’s operations were outside of traditional banking activities such as taking deposits and making loans. 

This state approved exception to the strictly established separations appeared to signal that the PBOC would begin to consider relaxing the imposed divisions.

While the PBOC gave itself an undefined ability to declare certain business practices permissible for some firms, they also gained the ability to ease the restrictions for some companies while maintaining the strict divisions for the vast majority of financial firms. 

The 2004 Memorandum of Understanding on Division of Responsibilities and Cooperation was designed to clarify the exact responsibilities of the China Banking Regulatory Commission, the China Securities Regulatory Commission and the China Insurance Regulatory Commission. 

In 2005 the PBOC allowed the Bank of Communications to begin to engage in fund management activities. 

The Chinese officials and government regulators felt that they had patiently developed a system that could gradually be reintegrated from the chaos that engulfed the unregulated markets 10 years before. 

As Chinese officials admired the international financial firms that, at one point in time, appeared to be almost bullet proof, they strove to slowly break down the walls that separated banking, fund managing, insurance, trusts and finance. 

As Liu Mingkang stated as the head of the CBRC in 2006;  

“Banks in Western, developed countries are increasing their capabilities and functions by the day. Jointly operating banking, securities and insurance businesses is a huge development trend.”

 And in the China Daily in October 2006; 

“The time is ripe not to make it clear that the barriers [between different financial businesses] will be torn down gradually to give our financial institutions an opportunity to become more competitive and thus make the whole financial industry more efficient.”

I asked some banking lawyers in Hong Kong what they thought the client’s chances for obtaining a loan in China were and they all agreed that it would be pretty unlikely.

Basically it is most unlikely that a foreign company without a track record of dealing with Chinese banks will obtain credit lines from Chinese banks.
 
Chinese banks are moving toward becoming standard Western commercial banks – they always look for profitable and safe investment, but this is a very slow movement.

When they do extend credits to what may look like risky borrowers, it is always because either they are pressed by local governments or some key bank managers are otherwise influenced in the decision making.

In practice, local governments may act in favor of major FIEs that matter to local economy, but perhaps not a “pure” foreign company.

So, unless they have a track record of doing a significant amount of business in China or they have funded major investments in infrastructure development or they employ a large number of Chinese workers they don’t have much of a chance.
 
You might be able to get financing if you can persuade a local government to give the banks a nudge, meaning you either employee a huge number of local Chinese in your company or JV or you have enough pull with the local government to get them to go to bat for you.

It got me to thinking about Chinese banking, the big 4 Chinese banks have some of the largest holdings of bank in the world, how do they make loans? Why would foreign businesses have such a difficult time getting funding? The answer comes down to a practice called “Window Guidance”.

Window Guidance is a favorite tool of the PBOC, this is an idea that is borrowed from the Japanese banking system.

The PBOC uses window guidance to “guide” the lending polices of the big 4 banks.

This is accomplished through a combination of moral pressure, to support the national government’s policy wishes, and the hidden threat of “complications” with money supplier from the central bank, as the PBOC controls this lending.

By allowing the market to make an “educated guess” as to what the lending policies of China’s biggest banks will be, the PBOC allows the largest banks to appear to act independently but in actuality, they are somewhere in between the planned economy and a completely market based economy.

While the central bank does not technically direct the lending of the big four banks, they do apply pressure in the banks to follow the governments policies.

The big four banks generally adhere to these policies because the PBOC provides the banks with loans.

These direct loans from the PBOC to the commercial banks are a very useful tool in maintaining the stability of the financial system.

Providing banks with a gift wrapped mini bail out allows them to work through difficult times without being completely accountable to shifts in the market.

The opposing argument, often heard regarding U.S. financial market bailouts, is that these types of low interest loans will encourage the banks to engage in risky behavior with less restraint, because they expect to be taken care of.

These financial institutions will then become too big or important to fail, forcing a government to take more responsibility in overseeing the operations.

Having the government’s monetary policy so closely intertwined with what are regarded as independent private banks in the west is a troubling thought for those that tout the free market over all.

But judging by the manner in which recklessness and greed played such an integral part in the deep troubles of the American and European banking systems, maybe having a government oversight committee is an intelligent move.

Giving the committee some real power to act and intervene when it sees potential abuse seems to be an intelligent solution to the West’s current banking system difficulties.

Window guidance is a very important tool for the PBOC, it will play a major part in the Chinese government’s 2009 economic stimulus plan.

The central bank has made it very clear that they expect their contributions to the economic stimulus package to be matched, on a 1 to 1 ratio, by the big four central banks.

This is also a policy that the West should strongly consider using, there needs to be some balance between allowing a free market to guide itself and making the big national banks into puppets that are incapable of making intelligent decisions of their own free will.

The type of cooperation that China promotes between the responsible government agency and the banking sector is a model that the west should attempt to emulate with the shares they have acquired “bailing out” western banking entities.

Next on the list are leftovers from China’s years of a central planning style of government.

At that point in time, China’s economy had no corporate growth strategy or marketing, they simply produced what they were directed to produce for the Chinese domestic market.

Because these industries employed some many people, they were essential sectors of the economy and were given VIP cards and and first in line for loans from China’s big four state owned banks.

This is eerily similar to the current situation the US gov’t finds itself in, GM and AIG have basically become American state owned enterprises, they are too big and employ too many people to be allowed to fail.

The main source of China’s 4 large asset management company’s assets are hundreds of millions of dollar in non performing loans to state owned entreprises.

This is very similar to the “Toxic Bank” idea that was tossed around in the US as a way to let banks clear bad loans from their balance sheets and help them recover from making so many loans based on dollar signs and fuzzy logic.

As China moved towards a market economy in the early 1980’s these blank checks to the massive state owned companies started to dry up.

The government realized that they could not afford to continue to loan these company’s massive amounts of money and expect nothing in return but stable employment.

This credit plan was officially abandoned in 1998, although state owned companies are still propped up with massive loans. 

This is still a major issue for Chinese small and medium sized businesses,  they often have much more efficient business operations but, more often than not, are unable to get business development loans the results of  large corporations feeding on loan money like great white sharks on seals.

The development of China’s middle class, and a strong stable internal consumer market, will depend on their abaility to encourage  small and medium companies to develop.

I will do a series of posts that are designed to provide specific information about the structure of Chinese banking regulation, how it is changing and the direction it is heading.

For all of China’s history the way that power is held is economic stability.

No matter how bad things get for people, as long as they can put food on the table, they are generally satisfied.

The People’s Bank of China has inherited the modern “Mandate of Heaven”, the main responsibility is to keep a stable economy. The people of China don’t really care how they do it, the end result is all that matters.

The PBOC (People’s Bank of China) has many tools that it can use to control and maintain stability, the method of choice is the required reserve ratio.

Basically, the PBOC directs the big four on the minimum amount of customer deposits that they must hold.

The point of this is to stop a Chinese version of “It’s a Wonderful Life”, Jimmy Stewart isn’t going to make sure that there are no runs on Chinese banks.

Besides stopping runs on the banks, this method of control also influences how much business a bank can do. Banks make money by making loans, they would probably loan out every single RMB note we deposited if they could.

By forcing them to hold more money, banks can’t do as much business, by letting them loan out more of our money, they can do more business.

China changes the reserve amount a lot, 9 times in 1997, in order to control inflation. I thought my aiyi was on the take when I was eating ribs for breakfast.

Numbers and stats on inflation don’t usually spark unrest, but when people see their grocery bill start to climb they get anxious.

By increasing the reserve requirement, the PBOC forces the banks to tighten their belts and make less risky loans, because there is less money pouring out, inflation goes down and I can have pork chops for breakfast again.

By forcing the banks to think twice about their business, the PBOC can control the amount of money loaned and maintain the strength of the currency actually used by people to make purchases.