The west should heed advice from China’s bank regulators

June 16, 2009 5:34am
by Arthur Kroeber

By Arthur Kroeber

We had the somewhat qualified pleasure last week of attending the spring meeting of the International Institute of Finance — the assemblage of the great and the good of the world banking industry— which this year was held in Beijing.

Although as usual for such events there was a certain amount of high-level pabulum, two clear messages emerged from the cogent presentations by Chinese speakers.

First, China provides some useful lessons for western governments as they contemplate how to redesign their financial regulatory systems. Second, the prospects for significant financial-sector reform within China are rapidly brightening. This week we shall deal with the first.

Until roughly three years ago, many outside commentators argued that China’s state-driven financial mechanism, which funnelled cheap credit to state-owned industrial enterprises with little regard to efficiency or return on capital, would inevitably generate a huge pile-up of non-performing loans leading to a financial crisis.

To generate sustainable long-term growth, they contended, China would have to adopt the vastly more efficient capital-allocation mechanism of western banking systems and capital markets.

The problem with this argument was that efficient capital allocation matters a lot in mature economies at the technological frontier with structural growth rates of 2-3 per cent. But it matters far less in developing economies where favourable demographics, a high savings rate, urbanisation and technological catch-up conspire to create a structural growth rate of above 8 per cent.

In China, where the financial system is seen as a utility facilitating the activities of the real economy rather than as an individual source of wealth creation, it can be perfectly rational to suppress its profits to increase the profits of firms in the real economy.

The resulting reduction in financial-sector rents actually makes a financial crisis less likely, because excessive risk-taking is suppressed.

Remarks given at the IIF meeting by the suave Liu Mingkang, head of the China Banking Regulatory Commission (CBRC) since its creation in 2003, suggest that there is another reason to be relatively sanguine about the health of the Chinese financial system: its regulators appear to have a better idea of what they are doing than their western counterparts.

In contrast to western regulators, who put bank regulation on auto-pilot via the model-driven and extremely pro-cyclical Basel II capital adequacy system, Mr Liu made a persuasive case for the enduring value of old-fashioned bank supervision tools such as limits on single large exposures, a conservative 75 per cent loan-to-deposit ceiling, limits on simple leverage ratios, and “window guidance” on exposures to specific companies and sectors.

As Mr Liu cogently summed it up: “Basel II is problematic; traditional ratios are still useful. Small is beautiful and old is beautiful as well.”

There is certainly plenty of garbage hidden in China’s banks, and new garbage is being created at a rapid rate through the vast expansion of lending under the government’s economic stimulus programme. But strong balance sheets and the sensible regulatory framework suggest that financial crisis risk in China remains low.

Mr Liu concluded with several recommendations for regulatory redesign that western governments would do well to heed:

* monetary policy must take account of asset prices as well as consumer-price inflation;

* the capital markets should never be the primary source of funding for banks;

* traditional prudential ratios should be used where appropriate to supplement capital-adequacy ratios;

* and regulators should use judgment and discretion to modify the actions suggested by their models.

None of these recommendations is incompatible with a light-touch regulatory system appropriate for a more advanced financial system that enables innovation and true efficiency gains. They boil down to saying that market ideology should not be allowed to trump common sense, and that regulators would do best to remember the basic utility function of banks and treat with grave suspicion claims about financial institutions as independent sources of value creation.

June 16, 2009 5:34am in Banking, Economy, Finance, Financial reform | Comment