By Zhang Chenghui, Research Institute of Finance of DRC

Research Report Vol.17 No.6, 2015

Since the Third Plenary Session of the 18th Central Committee of the Communist Party of China, many reform measures have been implemented in China’s financial sector such as the marketization of interest rate, wider opening-up, and streamlining administration and delegating more power to lower-level governments via Shanghai Free Trade Zone(China), the to-be-adopted IPO registration system,issuing the reform plan for policy-based banks,more efforts in promoting the development of insurance market and other related reforms. Despite all these measures, some underlying problems in the systems have not been properly addressed. Thus, not much significant effect has shown, and the improvement of financial service has been far from enough to satisfy the need of economic restructuring.

I. Underlying Problems in China’s Financial Reform

1. How to reshape the behavior pattern of government’s management over financial sector

This question is the core of all institutional problems, the essence of which is how to adjust the relationship between government and financial market, and how to reallocate the interests between the central and local governments. Admittedly, as one player in the financial market, government cannot detach itself from the market and regulate it merely as a neutral third party.In fact,government is actually one of the holders of the interests. The government’s interests vested in financial market are reflected at three levels. First, through its control over financial institutions and financial market (equity-holding or non-equity-holding), government exercises its impact on the allocation and reallocation of financial resources so as to make sure capital flows into government-supported areas and sectors.Second, through its impact on financial transactions (such as implicit guarantees for financial goods and assistance to avoid business failure for financial institutions), government maintains financial even economic and social stability, reduces fiscal expenditure on mitigating risks, especially when state capital dominates in most major financial institutions. Third, through deep involvement in financial activities, administrative departments of financial sector expand the scope of their functions.

Due to enormous interests, central and local governments are usually unwilling to hand in the function which should belong to the market back to the market. It is easier to say “let the market play a decisive role in resource allocation and let the government play its due role”. Government’s intervention in financial activities and financial market takes many forms as follows. Claiming that financial sector matters in national economy and requires control, government continues to hold the majority of the shares in financial institutions and directly appoint high-level management; Through administrative power, government orders financial institutions devote their support mainly to government projects. (This is particularly true on the level of local governments. Government’s intervention even intensifies when economic growth slows down, and local governments have growing pressure to maintain economic growth.) Administrative departments of financial sector directly establish and regulate financial market, even setting up “one specialized market for one product”. A great number of government-controlled funds are set up in various forms. These are just a few examples of government intervention in financial markets. From the perspective of behavior pattern, government officials are more willing to intervene directly in financial institutions with administrative controls because of the simplicity, directness and quick effect rather than indirectly guide and affect resource allocation through market mechanism, due to the relatively long feedback time and small rent-seeking space. Contrary to what the central government recently requires, some financial administrative departments don’t delegate their power to lower-levels. Instead, they even tend to strengthen their power and manage the financial sector in a more detailed way.

2. How to promote deeper reform in major financial institutions

In recent years, financial reform has encountered some resistance under theinfluence of ideology and vested-interest groups. Some recent reform measures imply that policies orient to “making breakthroughs from outside”. For example, efforts are made to promote the establishment of private banks, to be more tolerant towards the development of Internet finance, and to vigorously develop all sorts of financial institutions including small loan companies, financing guarantee companies, financial leasing companies, and capital management companies. Despite some effects of the strategy of “making breakthroughs from outside”on boosting the development of real economy, it does not address the problem of reforming major financial institutions. There are several reasons. First, the emerging institutions are too small to change the overall landscape of financial competition. For example, even if 100 private banks are set up, each with a capital of 2 billion yuan, their total assets are no more than 2 to 3 trillion yuan , while the total assets of the financial institutions in banking sector currently have already reached over 180 trillion yuan. Obviously, it is competitiveness and risk control ability of the major financing institutions that play a key role in determining service efficiency and risk degree of China’s financial system. Second, based on the experience of Taiwan, rapidly removing the threshold of market access to private banks leads to a large number of banks, excessive competition, profit decline in banking sector and rising non-performing loan ratio. In the early period of this century, financial regulatory authorities in Taiwan were under great pressure to deal with the financial risks brought by private banks. Third, financial regulatory pressure of local governments increases with the rise of the number and types of financial institutions. With diversified economic development levels and governance abilities, provinces differ much in their regulation over the financial sector. Accordingly, the inconsistency of market rules and regulatory efforts can easily bring about financial disorder and regulatory arbitrage. Recent years frequently witness illegal business of financing guarantee companies and small loan companies. Financial risks have spread to formal financial system.

Currently, major financial institutions have the problems of non-standardized corporate governance, lack of headquarters control and risk control ability, alienation of market competition behaviors. The external reasons for these problems are implicit guarantee and ill market discipline. The internal reasons lie in the excessively high proportion of state-owned shares and the excessive intervention of administrative power. Problems in corporate governance mainly include the following. First, there is a widespread phenomenon that a company is dominated by a single large shareholder and insider control. The check and balance by small and medium shareholders are weakened or even missing. Currently, it is estimated that government has direct or indirect shareholding of about 60%-70% in major financial institutions. Excessively high proportion of state-owned shares, along with a complex and multi-layer principle-agent system of state-owned assets, result in the difficulty for the principles to exercise effective regulation and supervision over agents, loss in information transmission across layers, and increase in regulatory cost. Second, systems of board of directors and board of supervisors are not sound. On the one hand, directors and supervisors are usually selected without caring about market-oriented operation of financial institutions. The board of directors and board of supervisors take in a large number of non-professionals. To some extent, the boards even become home to officials without promotion prospect on their career ladder. On the other hand, functions of board chairman and bank president are not clearly defined. In many institutions, the chairman is not only the highest representative of stockholders’ interests in the company, but also in charge of routine management. Because the board of directors and the chairman are not virtually the holders of decision-making power or the administrative authority to appoint and remove managers, in order to avoid being removed from practical control, the board chairman has to intervene in routine management. And the relationship of chairman and bank president changes into “chairman first, president second”, which, to a large extent, distorts the principle-agent relationship. Third, excessive non-market factors exercise strong impact on the selection of company’s top management. On the one hand, government usually appoints the top management of the headquarters of financial institutions. (In some financial institutions controlled by private capital like the Rural Credit Union, its management at the provincial level is also appointed by the government.) In most cases, government officials are appointed to these positions. On the other hand, the concept of “top management” is broadly defined. Even the managers of the subbranches of commercial banks and insurance companies are appointed with the approval of relevant departments or their offices, which greatly constraints the authority and power of the headquarters of financial institutions. The most critical issue is that the appointment of management is not incentive-oriented based on business activities and market evaluation, but is increasingly influenced by and subject to government administration.

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