China Is Overhauling Its Regulatory Framework. Why Now?

Trust and stability.   In our view, the overhaul is ultimately aimed at strengthening trust and stability in the country's financial system. The stability of banking systems is paramount for any economy. So is trust--as underlined by U.S. authorities acting quickly to stem fallout from the failure of three U.S. banks, or the Swiss authorities brokering an emergency rescue deal between UBS and Credit Suisse.

Curbing deficiencies and loopholes.   The overhaul, announced at last month's "Two Sessions" annual governing event, also addresses regulatory gaps. An increasing number of risk events highlight some deficiencies in the financial supervision. The notable risks include:

• Struggles to keep pace with new types of businesses and emerging risks. Such as include multilayered wealth management products (i.e., umbrella trusts) or cross-region online deposit-taking business (e.g., Henan Rural Bank event in 2022).
• Supervisory inconsistency among multiple authorities, especially at the regional level. For example, the oversight around high leverage ratios across micro-lenders in some regions.
• Insufficient supervision for non-licensed financial business. One notable example is the rapid growth of peer-to-peer (P2P) platforms under the oversight of provincial governments, which lacked the expertise to set standards. Tighter rules were implemented in 2019 – which led to an abrupt shut-down of the P2P market. However, the resulting chaos remains unsettled with lenders still seeking compensation.

A must have.   In our view, China's wide geographic spread and economy require a unified and efficient regulatory system. Aligning different regulators under one roof should help bridge the regulatory loopholes and supervision priorities. Furthermore, a centralized approach facilitates consistency in supervision, especially at the local level.

Centralization of powers.   The Two Sessions in 2023 points to firmer and more centralized controls. Besides regulatory consolidation, major changes are planned for several government bodies, and new ministries will be established. Given the emphasis on longer-term economic and financial stability, we think China is unlikely to return to a growth model driven by credit and public investment over the next year or two (see "What The "Two Sessions" Say About Chinese Government Finances," published on RatingsDirect on March 20, 2023)

Most significant reform since 2018.   As a "super regulator," the National Financial Regulatory Administration (NFRA) will oversee all of China's financial services sector, except securities. The latest reform trails after its last revamp in 2018 when the banking and insurance regulators were combined to form China Banking and Insurance Regulatory Commission (CBIRC). With this, China's super-regulator formation will become the largest (in terms of the size of financial assets under its aegis) globally (see table 1).

Table 1

What's Changed In This Overhaul?

Formation of NFRA.   The new super regulator will be placed directly under the State Council. It replaces CBIRC, and will assume oversight of financial holding companies, and financial consumer and investor protection--duties previously undertaken by People's Bank of China (PBOC) and China Securities and Regulatory Commission (CSRC) (see table 2).

Table 2

PBOC focuses on monetary policy.  With this transformation, financial holding companies such as Ant Group (China's fintech giant) will be regulated by NFRA. Previously, PBOC was the supervisor. Going forward, PBOC will focus on monetary policy setting (like that of the Fed).

CSRC gets upgraded.  The CSRC will be raised to become a government agency directly under the State Council from its earlier public institution role. It will continue to supervise the securities market. In addition, CSRC expands its oversight to include approval of enterprise bonds (on top of corporate bonds); a role it has taken over from the National Development and Reform Commission NDRC.

PBOC reforms branches.  Under the plan, PBOC will discontinue its large regional branches, and instead, will create provincial branches in all 31 provinces, and city-level branches (in Shenzhen, Dalian, Ningbo, Qingdao, and Xiamen). In addition, special branches will be established in Beijing and Shanghai. Concurrently, the county-level branches will be abolished, and their functions will be transferred to the city-level branches. In place, we anticipate NFRA to establish local presence to facilitate supervisory oversight.

However, more details needed.  Some missing parts remain in the regulatory overhaul plan. One example is lack of explicit mention about the supervisory responsibilities of the "7+4" type local financial institutions (i.e., micro lending companies, financing guarantee companies, pawnshops, local asset management companies and etc.), which are regulated by local governments, mostly. Likewise, the department responsible for issuance of financial holding company licenses is unclear.

What Are The Implications From This Change?

Easier said, more time needed.   While we believe the intentions of this overhaul are good (streamline cooperation across different financial regulators, stem out illicit practices in finance, and streamline operations), the execution will be time consumptive. In particular, the clearing up of PBOC's branch networks be a multi-year project.

Some delays abound.   NFRA will need time to get the ground rules ready. This means regulatory approvals may slow and face delays. For the insurers, this will derail strategic and financial plans to boost capital as part of C-ROSS Phase II. Concurrently, the centralized supervision of banks, and insurance companies (moving away from local supervision) could demand more experienced personnel. Meanwhile, employees at CSRC will be paid on par with the nation's public servants, insinuating a pay-cut for some, risking turnover.

Need for policy clarification.   Meanwhile, the sudden centralization of risk management oversight will need to clarify existing policies--posing uncertainties and inconsistency (though temporary) over prospective policy directions. Some of the local and regional governments (LRGs) could seek to distance themselves from supporting the local state-owned enterprises (SOEs) amid policy clarification. For some of the overleveraged local SOEs, this temporal disconnect could see funding support fall through the cracks, risking defaults (see "China's SOEs Are Stuck In A Debt Trap," Sept. 20, 2022). Furthermore, distressed SOEs could implicate economic growth and local stability.

Behavioral change.   Prior to this change in regulatory framework, local governments could function as both regulatory supervisor and shareholders to financial institutions--giving rise to conflicting priorities (profits or risk management). However, under the new rule, local governments will no longer perform the roles of regulatory supervision. This means some LRG-linked financial institutions will abide to regulatory supervisors' focus on risk management and could delay or refrain responding to LRGs' mandates of supporting distressed SOEs.

Looking Ahead

Execution is key.   The aim to centralize is clear in government's agenda and blueprint for China. The alignment of the financial services sector, like a jigsaw, will be instrumental to facilitate consistent rollout of future policy packages and responses. However, execution is key (i.e., having the right people and the determination to follow through).

China's geographical scale, differing conditions across the regions, will entail upending existing rules. We believe this process will be long where hidden risks could be uncovered, unfortunately. We expect some hard decisions will be required to balance intent and practical execution.

Related Research

• What The "Two Sessions" Say About Chinese Government Finances, March 19, 2023
• China's SOEs Are Stuck In A Debt Trap, Sept. 20, 2022