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Banking regulation in China: what, why, and how? Wei Ping He School of Law, University of South Australia, Adelaide, Australia Abstract Purpose – The purpose of this paper is to provide an overview of China’s contemporary banking regulatory system, with particular focus on regulatory control of foreign banks trading in China. The paper addresses three aspects of Chinese banking regulation: what does China regulate; why does China regulate; and how does China regulate. Much of the discussion is concerned with China’s regulatory agencies particularly with the role of the CBRC as the principal regulator in China’s banking sector. Design/methodology/approach – In the first instance the paper presents an overview of banking regulatory models gained from a review of theoretical literature in the area. Then through a wide ranging review of Chinese publications, both academic and official, the paper seeks to relate the course of regulatory reform in China, both in terms of compliance with orthodox regulatory theory, and the unique regulatory requirements of the Chinese banking system. Findings – The paper recognises that China has embraced the need for banking regulation with the establishment of an institutional structure that is responsive to both banking supervision and government policy. Within that structure the role of the CBRC, the pervasive manner in which that agency operates, and the content of its regulatory output have been identified and critically reviewed. Originality/value – In its review of the modernization of China’s banking regulatory system, the paper achieves originality from the author’s research into, and critical reflections on Chinese generated literature, both institutional and academic, which is then communicated in a manner that will be understood by readers familiar with Western banking regulatory theory. Keywords Banking regulation, Banking regulation in China, Banking, China Paper type Research paper I. Introduction In 2002, the 16th Chinese Communist Party National Meeting called for reform in the financial sector (Zemin, 2002). Privately owned enterprises were recognized as an essential component of the financial market. This policy statement embraced active promotion of private ownership in China’s banking sector. The role of the government, from being a dominant force in the market, was to be transformed into being a facilitator of the market economy. This transformation was accompanied by other initiatives including encouraging foreign banks to take minority stakes in historically state-owned banks. China’s banking sector has thus embarked on a reformatory journey since 2003. This article commences with the establishment of the Chinese Banking Regulatory Commission (CBRC) in 2003. That is the point from which the modernization of Chinese banking regulation begins. It is the point at which China consolidated its regulatory institutional structure by developing specialised regulators. Following this, a comprehensive set of regulatory initiatives and a unique regulatory approach was developed. The purpose of the paper is to provide an overview of China’s contemporary banking regulatory system, with particular focus on regulatory control of foreign The current issue and full text archive of this journal is available at www.emeraldinsight.com/1358-1988.htm Banking regulation in China 367 Journal of Financial Regulation and Compliance Vol. 20 No. 4, 2012 pp. 367-384 q Emerald Group Publishing Limited 1358-1988 DOI 10.1108/13581981211279336

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Page 1: Banking regulation in China: Banking what, why, and how ... · PDF filebanking sector. Design/methodology ... Banking regulation in China, Banking, ... That is the point from which

Banking regulation in China:what, why, and how?

Wei Ping HeSchool of Law, University of South Australia, Adelaide, Australia

Abstract

Purpose – The purpose of this paper is to provide an overview of China’s contemporary bankingregulatory system, with particular focus on regulatory control of foreign banks trading in China.The paper addresses three aspects of Chinese banking regulation: what does China regulate; whydoes China regulate; and how does China regulate. Much of the discussion is concerned with China’sregulatory agencies particularly with the role of the CBRC as the principal regulator in China’sbanking sector.

Design/methodology/approach – In the first instance the paper presents an overview of bankingregulatory models gained from a review of theoretical literature in the area. Then through a wideranging review of Chinese publications, both academic and official, the paper seeks to relate the courseof regulatory reform in China, both in terms of compliance with orthodox regulatory theory, andthe unique regulatory requirements of the Chinese banking system.

Findings – The paper recognises that China has embraced the need for banking regulation with theestablishment of an institutional structure that is responsive to both banking supervision andgovernment policy. Within that structure the role of the CBRC, the pervasive manner in which thatagency operates, and the content of its regulatory output have been identified and critically reviewed.

Originality/value – In its review of the modernization of China’s banking regulatory system, thepaper achieves originality from the author’s research into, and critical reflections on Chinese generatedliterature, both institutional and academic, which is then communicated in a manner that will beunderstood by readers familiar with Western banking regulatory theory.

Keywords Banking regulation, Banking regulation in China, Banking, China

Paper type Research paper

I. IntroductionIn 2002, the 16th Chinese Communist Party National Meeting called for reform inthe financial sector (Zemin, 2002). Privately owned enterprises were recognized as anessential component of the financial market. This policy statement embraced activepromotion of private ownership in China’s banking sector. The role of the government,from being a dominant force in the market, was to be transformed into being a facilitatorof the market economy. This transformation was accompanied by other initiativesincluding encouraging foreign banks to take minority stakes in historically state-ownedbanks.

China’s banking sector has thus embarked on a reformatory journey since 2003.This article commences with the establishment of the Chinese Banking RegulatoryCommission (CBRC) in 2003. That is the point from which the modernization of Chinesebanking regulation begins. It is the point at which China consolidated its regulatoryinstitutional structure by developing specialised regulators. Following this,a comprehensive set of regulatory initiatives and a unique regulatory approach wasdeveloped.

The purpose of the paper is to provide an overview of China’s contemporarybanking regulatory system, with particular focus on regulatory control of foreign

The current issue and full text archive of this journal is available at

www.emeraldinsight.com/1358-1988.htm

Bankingregulation

in China

367

Journal of Financial Regulation andCompliance

Vol. 20 No. 4, 2012pp. 367-384

q Emerald Group Publishing Limited1358-1988

DOI 10.1108/13581981211279336

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banks trading in China. The paper addresses three aspects of Chinese bankingregulation: what does China regulate; why does China regulate; and how does Chinaregulate. These propositions wherever possible will be related to regulatory measuresin the areas of entry and operations of foreign banks in China. Much of the discussionwill be concerned with China’s regulatory authorities and in that regard is primarilyconcerned with the role of the CBRC as the principal regulator in China’s bankingsector. The paper seeks to highlight the significant role that the CBRC plays in China’sregulatory discourse, and consequently the construction of the banking regulatorylandscape in China. From here, readers will be in a position to form views as to thenature of China’s banking regulatory system and as to some unique regulatory featuresthat may not be well understood in foreign jurisdictions.

II. What does China regulate?When reviewing China’s regulatory institutional structure, a starting point is theformation of the CBRC. With a view to creating specialised regulatory bodies, in April2003, the 10th National People’s Congress Standing Committee approved the proposalby the State Council that the CBRC should replace the People’s Bank of China (PBoC) asthe principal supervisory and regulatory body within the banking sector. The CBRCwas to be accountable to the State Council. The PBoC’s role was reduced to thesupervision of monetary policy[1].

By separating banking regulatory supervision and monetary policy, and creatingthe CBRC, China took a significant step toward pursuing a better and stronger bankingregulatory framework. The CBRC operates pursuant to an express statutory grant ofthe National People’s Congress. The main responsibility of the CBRC was forprudential regulation and protecting depositors by reducing banking risk[2]. CBRCprovincial offices took over the regulatory role previously held by provincial branchesof PBoC (Wang, 2003). Therefore, as it was with PBoC, the regulatory structure withinthe CBRC took on the provincial administrative model employed by the Chinesegovernment in its general administration. It is interesting to observe in this regard thatforeign banks are strategically regionally focused, concentrating their resourcesparticularly in three high-growth regions, Yangtze River Delta, the Pearl River Delta,ant the Bohai Bay area (ANZ, 2009).

The establishment of the CBRC as a principal regulator has been highly regardedas a milestone step forward towards a stronger and more effective banking regulatorysystem. The major justification for divorcing the regulatory activities from the PBoCwas that, in engaging in monetary, as well as regulatory activities, the PBoCwould experience conflicts of interest (Shi, 2004) caused by the interaction of micro(regulatory) and macro (monetary) policies (Goodhart and Schoemaker, 1993). Thecreation of the CBRC also represented an acknowledgment by the Chinese authoritiesof a deficiency in its banking regulatory system; particularly, a lack of marketdiscipline and inadequate regulation of risk management (Shi, 2004).

Although it has been stripped of banking regulatory power, nonetheless, the PBoCstill plays a crucial role in the Chinese banking sector. As noted above, under thesupervision of State Council, the PBoC is now primarily concerned with making andimplementing monetary policy, with a focus on the macro-economy, and the safety ofentire financial system[3]. In accordance with its enabling legislation, the PBoCsupervises interbank markets, the payment, and, the settlement system, and credit

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information system[4]. These are crucial to the operation of individual banks. The PBoCremains the guardian of the systemic safety of the entire banking sector. However, inthe absence of a formal deposit insurance scheme in China, the Chinese governmentplays a role as a lender of last resort in the event of crisis. In the wake of the globalfinancial crisis in 2007, the Chinese government provided an implicit guarantee forretail deposits (Kang, 2010), to insure against the unraveling of the financial systemand economy.

In addition, the PBoC oversees the State Administration of Foreign Exchange(SAFE)[5]. Although the legislation that created the SAFE does not contain implicit orexplicit mandates, the PBoC has delegated to the SAFE the power to supervise andregulate the foreign exchange market (PBoC, 2010). Chapters 2-4 of Rules of Foreignexchange regulation of People’s Republic of China (1997) describe the jurisdiction of theSAFE. Here it is stated that SAFE takes regulatory responsibility for all bankingbusinesses related to foreign currencies.

Three other governmental departments are also of relevance to foreign banks.These are the Ministry of Finance (MoF), the National Development and ReformCommission (NDRC), and the State-Owned Assets Supervision and AdministrationCommission (SASAC) together with their local affiliates. The Ministry of Finance is themajor executive body for government financial policies. It is also mandated to managethe financial industry at a macro level, and to guide financial institutions as to theirentry and operation in the Chinese markets (Ministry of Finance, 2011). The ministryand its local affiliates play a role in introducing foreign banks to other regulators.The National Development and Reform Commission regulate the pricing of bankingservices and products (National Development and Reform Commission, 2011).The SASAC is charged with overseeing state-owned entities (SOEs) (Li, 2010).Although the SASAC does not have jurisdiction over foreign banks operating in China,its operations concern these because of their dealings with SOEs, most notably withChinese banks.

On some occasions, these authorities can have significant incidental impact onforeign banks operating in China. For example, in 2008-2009, some SOEs sufferedconsiderable losses, reportedly more than 11 billion in yuan (China Finance Net, 2009),in dealings with derivative products via foreign banks. Consequently, the SASAC issueda notice prohibiting SOEs’ use of speculative derivative transactions (Li, 2009). Theintervention by the SASAC took foreign banks by surprise, and resulted in significantlosses being suffered by the foreign banking institutions involved. As a result, it isreported that foreign banks were largely excluded from what had being a key source ofrevenue, with their derivatives business being wound down (Financial Times, 2009).

This incident demonstrates that foreign banks run a significant risk of suddenunexpected changes in government policies and resultant interference in bankingactivities in a manner and to a degree that they may not be accustomed to in their homejurisdictions. Foreign banks need to be aware of the scope of the activities of thesethree authorities and uncertainties their activities can generate.

The CBRC stands on an equal footing with PBoC and the other three governmentalagencies, with all organisations exercising different functions within the bankingsector, but with all of them being accountable to the State Council. In particular, theCBRC is subject to Chinese government directions with respect to its regulatoryinitiatives. It is the central government’s stated intention that CBRC shall operate free

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from intervention by local governments[6]. The law does not however insulate CBRCfrom control by the State Council.

In 2006, a landmark regulatory initiative, Regulations of the People’s Republic ofChina on Administration of Foreign-Funded Banks (Regulation (2006)), waspromulgated by the Central People’s Government. This primarily concerned foreignbanks’ entry into Chinese banking sector in the form of representative offices, foreignbranches, and local incorporation. It mandated that the CBRC had comprehensive powerto license and regulate foreign banks that provide banking business in China.In interpreting and clarifying provisions in Regulation (2006), the CBRC enacted theRules for Implementing the Regulations of the People’s Republic of China onAdministration of Foreign-Funded Banks (2006)(Rules(2006)). Under s 3 of Rules (2006),the CBRC required foreign-funded banks to comply with prudential requirementsrelated to reputation, sound business performance, competent managerial personnel,risk management system, internal control, and corporate governance[7]. Pursuant to s21 of the Law (2003), prudential regulation also extends to areas of capital adequacy,asset quality, loan loss provisioning, risk concentrations, connected transactions andliquidity management. Acting on this, the CBRC has taken on an entity-specificapproach to ensure the sound operation of individual banks in China. One feature in thisregard is CBRC’s emphasis on banks’ loan-to-deposit ratios. This is currently set at75 percent[8]. The CBRC reportedly will monitor this ratio on a daily basis fromJune 2011 (Xinhua, 2011). The rationale for this ratio derives from the fact that bankingbusiness conducted by Chinese banks is mainly loan focused, thus a loan-to-deposit ratiorequirement is a simple way to control loan size and to ensure adequate liquidity inChinese banks. Since a loan-to-deposit ratio is not normally adopted by regulators inother jurisdictions, foreign banks’ local incorporated operations have been given a fiveyear window to comply[9]. Foreign banks have continued to raise concerns as to theirability to conform the 75 percent loan-to-deposit ratio by 2011 as they are comparativelyweaker in generating local deposits (PwC, 2010, p. 57).

Following the global financial crisis, the CBRC introduced new macro prudentialregulatory measures to address pro-cyclicality and to strengthen the resilience of theentire banking sector (Basel Committee on Banking Supervision, 2010). These includeda higher capital ratio, and, leverage and provisioning ratios. In particular, theprovisioning ratio on expected loss is set at 2.5 percent[10]. This ratio, which refersto expected loss provisioning in terms of overall loan size, aims at controllingnon-performing loan. Foreign banks feel this ratio is unduly restrictive on them.In general terms, foreign banks in China possess an advantage in risk managementover Chinese banks (Hope et al., 2008). Thus, application of a 2.5 percent expected loanloss level to all banks, does not properly reflect foreign banks’ actual expected creditlosses and fails to recognize foreign banks’ margin in risk management.

The CBRC is also a regulator for business conduct. One key element of China’sbanking regulation is that all banking products or services fall within the regulatoryframework. In accordance with s2 of Law (2003), prudential regulation is not onlyapplied to banking institutions but also to their banking business products andservices. Information disclosure is therefore an integral part of the CBRC’s regulatoryreach to ensure business conduct of banks consistent with regulatory expectations.One of the CBRC’s specific objectives is to increase public knowledge about financialproducts, services and the related risks through education and information

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disclosure (CBRC, 2009, p. 16). Overall, the CBRC takes a broad and rigorous approachto the regulation of banking products and services. Approval of banking productsmust be sought from the CBRC on a one-by-one basis[11]. For instance, localincorporated foreign banks need to apply for individual licenses for core bankingbusiness, such as yuan business or bank card business.

Within its articulated regulatory power in relation to banking institutions and theirbusiness[12], the CBRC performs its rule-making function on a pervasive basis. Theextent of reliance on prescriptive rules is extensive, ranging from housing financialservices to syndicated loans. Provisions contained in those rules are made to guide banksin measuring risk and business contracting. As an example consider the Rules on AutoLoans (2004). A number of features in this regulation indicate that the CBRC attempted tobring all aspects of auto loans under regulation. Sections 9 and 10 dictate six factualeligible requirements and four other eligible considerations for a prospective auto loanapplicant[13]. Factual eligible requirements extend to matters such as prospectiveapplicants’ ability to repay debts and other eligible considerations include the usage ofpurchased auto vehicles. This regulation therefore goes beyond the boundaries ofinformation disclosure by incorporating business practicalities surrounding auto loans.Such “heavy touch supervision” is less evident in developed economies. Anotherexample of regulation of the same nature lies in the CBRC’s regulation of banks’ internalmanagement that encompasses appraisal of directors’ and officers’ performance bysetting appropriate behavior standards and evaluative performance criteria[14]. Forinstance, the CBRC has identified 11 circumstances where directors are not competent,including having failed to attend two-thirds or more board meetings in a financial year,and having failed to exercise voting rights properly to express dissent[15]. Again theseare more obviously prescriptive than general statements of directors’ duties which aremore common in the jurisdictions of developed countries.

It is safe to conclude that while it remains a prudential and business conductregulator, the CBRC also strives to facilitate and guide the commercial undertakings ofbanks. Dealing with under-developed Chinese banking institutions, the CBRC hastaken on the obligation of nurturing desirable banking practices in putting togetherthose commercial oriented initiatives, examples of which are given above. In order tofulfil this implicit role, as a consequence, the CBRC’s functions and powers of necessityembody all that is required to achieve those objectives and goals in its regulatoryprocess. Thus, an understanding of those implied powers, incidental to the CBRC’sregulatory function, provides further insights into China’s banking regulatory system.

In compensating for banks’ lack of substantial expertise and experience inparticular areas of internal management and risk management, the CBRC implementspaternalistic regulation designed to guide banks’ operations at a grassroots level.However, regulatory initiatives and exercised regulatory powers in this regard are notwithin the explicit powers given by its primary enabling legislation, Laws (2003).While the regulator is eager to offer the best possible practices to banks, theseregulatory initiatives may disadvantage some banks, in particular foreign banks,which already have highly developed practices in these areas of risk management andcorporate governance.

Furthermore, some regulatory measures exploit foreign banks’ weaknesses andenable Chinese banks to play to their own strengths and enable them to conductbusiness on more advantageous terms. By way of illustration, controlling banks’

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operational risk is an important part of prudential regulation[16]. In 2009, the CBRCincreased its supervision in terms of one aspect of operational risk identification –customer authentication. Banks are subject to stringent rules in dealing with corporatecustomers. Representatives of new corporate customers have to visit bank premises inperson and banks are required to videotape the contracting process. Compared to theirChinese counterparts, this new regulatory initiative disadvantaged foreign banks asthey normally do not have an extensive network of local outlets for customer access.Reportedly, a foreign bank incurred a substantial loss as a customer was not willing totravel to comply with this compulsory regulatory procedure (PwC, 2010, p. 60).

With well defined regulatory obligations vested in the PBoC and the CBRC, it is safeto conclude that an objective-based approach has been executed in accordance withthose various regulatory objectives. The PBoC is in charge of systemic regulationwhereas Chinese government remains the lender of last resort. The CBRC, on the otherhand, is accountable for prudential regulation, micro or macro, as well as the regulationof business conduct. Although it is not within its formal mandate, in exercising itsregulatory powers in the regulatory process, particularly in the course of itsrule-making, the CBRC also has a role in paternalistic regulation, where it takes a stakein commercial wellbeing of individual banks. As we have seen there is a significantregulatory incursion into the internal business management processes of banks by theCBRC through regulatory means. This reflects an historical association between theregulator and the regulated in China. The equity interest held by central and localChinese governments in Chinese banks, and the active role played out by governmentsin China’s banking reform (Song, 2008) has also significantly influenced the CBRC’sregulatory approach. Chinese banks’ inexperience in corporate governance, riskmanagement and product innovation has also made it necessary for the CBRC’s toundertake paternalistic regulation. In compensating for or remediating banks’commercial practices, in this way, the ultimate aim of the regulator is to improve the“low profitability of Chinese banks” (Garcia-Herrero et al., 2007).

III. Why does China regulateThe mandatory regulatory objectives of the CBRC reflect banking regulation under thepublic interest theory: to protect fair competition in the banking industry and to enhancethe industry’s competitiveness, to promote the safety and soundness of bankingindustry and maintain public confidence, and to protect the interest of depositors andconsumers (CBRC, 2010, p. 13).

In relation to foreign participation in the Chinese banking sector, Chinese regulatorsbelieve that Chinese banks are still vulnerable to foreign competition (Baxt, 2010).Foreign banks have a competitive edge in providing tailored products and service, andthey are able to leverage on new and better products and services already developed inhome markets (Achhorner et al., 2006). On the other hand, it is acknowledged that foreignparticipation and competition would assist in the development of the Chinese bankingsystem (Feng, 2003). Foreign equity participation has been viewed as a means to assistChinese banks overcome their lack of managerial experience, risk control capacity, andcorporate governance (PBoC, 2002). There has been an observable trend of continuinggrowth and expansion of products and services by Chinese banks (PwC, 2010, p. 1).The introduction of foreign banks was also expected to improve the competitivenessof the domestic banking system in the long term (Leung et al., 2003).

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However, the degree of openness is limited to a level that allows Chinese banks to learnfrom the practices of their foreign counterparts, gradually eroding foreign banks’competitive advantage. It does not allow foreign banks to operate in areas where it isdifficult for Chinese banks to compete in the short term, and where foreign banks mightobtain a competitive edge useful in the long run. Due to these unfavourable regulatoryinitiatives, foreign banks have been deprived of some leverage in competing with theirChinese counterparts. Customised banking products and services, once an area ofadvantage for foreign banks, have been progressively emulated by Chinese banks.Wealth management is a good illustration. In 2007, foreign banks were frustrated by thepace of regulatory progress in allowing the roll-out of their wealth managementproducts, an area where Chinese banks were inexperienced (KPMG, 2007). Three yearslater, wealth management product differentiation between foreign banks and Chinesebanks has blurred. It is acknowledged that foreign banks can now only compete withChinese banks in terms of wealth management business by providing a better service(PwC, 2010, p. 7). In this light again we see the CBRC as a paternalistic regulator innurturing growth and development of Chinese banks.

In the current Chinese environment, regulatory priority has been given to the safetyand soundness of the banking industry, and the security of domestic deposits.Vice-president of the CBRC, Wang, has articulated acceptance of foreign entrants isfirmly based on the premise that safety of China’s banking system remains assured(Wang, 2007). In fact, although foreign banks’ investment in the Chinese bankingsector has not been significant in relation to the overall size of that sector, it is apparentthat there has been an observable increase in foreign bank participation in terms ofabsolute assets value (CBRC, 2007a, 2008, 2009, 2010). Within their regulatoryobjectives, regulators seek to strike a balance between China’s financial stabilityand openness towards foreign participants. This balance is difficult to achieve as it isalso complicated by the CBRC’s role as a paternalistic regulator. In the end, thecompetitiveness of Chinese banks, and the competition between Chinese andforeign banks is critical to the openness of the banking sector.

In private interest theory, banking regulation can be captured by private parties,the regulator and the regulated entities. China’s case aligns with the perception thatpoliticians and political parties regulate to their own advantage and capitalize uponregulation for their own ends. Chinese banking regulations have long reflectedgovernmental policies. Since 1979, the banking sector has been used to supportstate-owned enterprises. Banks are directed to provide prompt loans with multiplechannels of supply, and to extended loan coverage in SOE industries[17]. Anotherobservation is that, as distinct from central government, local governments are alsobeneficiaries of banking regulations. Through local government financing companies,bank credit has been channelled to fulfil the needs of local governments’ fiscal policies.In 2008, the Chinese central government introduced a 4 trillion yuan stimuluspackage, to which local governments’ contribution was 2.82 trillion yuan (Xinhua NewsAgency, 2009). To address the magnitude of the fiscal challenge confronting localgovernments, banks have contributed 80 percent of the local governments’ loansobtained by the local government financing companies (Chang et al., 2010).

Since its inception, the CBRC, has developed a government policy-based regulatoryapproach, and, the 11th National Five Year Plan and National Macroeconomic Policieshave heavily influenced the CBRC’s regulatory practices (CBRC, 2009, p. 116).

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Through its regulatory directives[18], the CBRC ensured that credit was extended tothe rural economy in an attempt to overcome the perceived shortage of financial loansdirected to agricultural production in 2008[19]. Guided by the State Council’s policy,Finance Promoting Economy, the CBRC directed banks’ lending to support the ruraleconomy. The developing West China strategy has also been supported by the CBRCactively guiding financial institutions in that direction. Special treatment has beenextended to banking institutions that respond to such priority policies[20]. Foreignbanks are not immune from these policies and have been encouraged to set upbranches in rural and western areas through the imposition of less stringent marketentry requirements in comparison to urban areas[21]. In addition to branches, there hasbeen a new policy invention, county banks, available for foreign banks to use toexpand into rural and western areas. As an entry vehicle, county banks attractcomparatively lax regulatory requirements[22].

By exercising these regulatory powers, the CBRC fulfils its economic and socialobligations, with its rule making activities being aligned with governmentmacroeconomic policies. These initiatives are aimed at increasing the availability offinancial services, and potentially promoting economic development in China’s ruraland western areas. It is widely accepted that the increasing availability of financialservices (Olson, 2003), and boosting economic development (Alllio et al., 2004) arelegitimate goals for banking regulation. Increasing financial services in rural areas hasbeen a long standing characteristic of banking regulations in emerging economies(Nair and Kloeppinger-Todd, 2007). So too, social welfare considerations are used tojustify preferential credit policies towards the historically disadvantaged in China’srural and western areas. It is a banking regulatory approach designed to benefit thecountry at large.

As a result, commercial banks are engaged in significant state-directed lendingwhile the CBRC still has macroeconomic policy goals as its mandate (Bell and Chao,2010, p. 7). In this regard, banking regulatory objectives are dependent upon thegovernment’s economic policy, and banking regulation aimed at directed funding isused a substitute for taxation and generation of disposable credit for central and localgovernments. The objectives and direction of the banking regulations rely on thegovernment’s policy orientation. In China’s case, to reiterate, it is evident that politicalfactors play a huge role in shaping banking policies.

While banks have been important in helping the government achieve its economicobjectives (Bell and Chao, 2010, p. 8), there is a concern about the danger of makingcredit lending decisions without any adequate commercial consideration and that thismay be detrimental to the stability of the banking sector in the long run. It alsoundermines the interest of the regulated entities, violates market principles anddistorts banks’ commercial motivations. Banking policies should encourage banks tooperate efficiently and to make sound capital-allocation decisions based primarilyupon commercial considerations (Barth et al., 2006).

IV. How does China regulateA well established regulatory framework ensures clarity in regulatory expectations,certainty in implementations, and is necessary for a high level of compliance. Thefollowing discussion attempts to relate China’s regulatory framework to principles-based

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and rules-based, command-control and self regulatory approaches of banking regulation,and review the associated regulatory implications for foreign banks.

The Chinese banking regulatory framework is four tiered. At the top sits legislationenacted by the National People’s Congress. Legislation in this category is very limited.Only four pieces of legislation, namely, Laws of People’s Republic of China BankingRegulation (2003), Laws of People’s Republic of China People’s Bank of China (1995),Laws of Commercial Banks (2003) and Laws of People’s Republic of China CommercialBanks(2003) have been enacted by the National People’s Congress. The first, Laws(2003), is the enabling legislation for a banking regulatory body. Specific regulatorypowers are delegated to the CBRC by the legislature. A further initiative of greatimportance regarding foreign banks, Regulations of the People’s Republic of China onAdministration of Foreign-Funded Banks (2006), was produced by the State Council,and the CBRC subsequently issued interpretive rules on specifics, and these have beenimplemented accordingly[23]. The State Council and its agencies are authorized by theNational People’s Congress to perform an interpretative function in the course ofgovernment administration[24]. It is important to note that, as opposed to the NationalPeople’s Congress, initiatives that regulate foreign banks emanate from a lower level ofthe legal hierarchy, and the interpretative power is the preserve of the regulator.

The second tier is regulatory policies set by the CBRC. Those policies reiteratelegislative principles set out in legislation (CBRC, 2011). There have been a range ofpolicy matters addressed by the CBRC. Those policies are indicative of the CBRC’sregulatory and supervisory directions over the medium-to-long term[25]. The mediumterm goal of the CBRC focuses on a prudential framework whereas the long term goalis to provide a fair and competitive market (CBRC, 2008, p. 60). Among thoseconsidered most critical to the entry and operation of foreign banks is localincorporation policy. This refers to the policy initiatives in 2006 encouraging foreignbanks operating in China to incorporate locally in preference to operating as branchesof foreign banks, and providing associated regulatory incentives to the banks toundertake local incorporation. From a risk viewpoint, the CBRC considers that localcorporations are more controllable as opposed to foreign branches (CBRC, 2007a, p. 43).Foreign branches do not possess any independent legal personality in host countries,and parent banks are thus responsible for the liability of their branches (Cerutti andAriccia, 2007). Therefore, depositors in host countries will not have priority in any debtrecovery process in the event that the parent bank experiences financial difficulty(CBRC, 2007a, p. 43). The emergence of local incorporation policy at the time presenteda unique opportunity for foreign banks to expand in China and potentially conductretail business there. This is an example of a regulatory policy that was a proactiveinitiative of the regulator in response to perceived contemporary regulatory needs.However, from 2009 the local incorporation policy ceased as policy emphasis hasshifted to county banking[26].

The third tier is the CBRC’s guidances, notices, and rules. Most of the CBRC’sregulatory initiatives fall into this category. As China finds specific measures morehelpful than principles-based approach (Ping, 2011), guidances, notices, and rules areprescriptive in content and abundant in numbers. In general, the third tier of regulatoryinitiatives serves as a bottom rung of China’s banking regulation, and deals withcontemporary regulatory issues.

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A proportion of guidances, notices and rules seek to regulate banking activities, bankingproducts, codes of conduct or practice, and internal governance. For instance, with regard toloans for the acquisition of fixed assets, regulatory rules provide specific guidance onapplicant evaluation, risk assessment, contracting process, loan disbursement, andaftermath monitoring[27]. In particular, Section 25 of the relevant Guidelines states thatwhere a loan exceeds 5 percent of the value of the fixed asset or 5 million yuan a lendertrustee payment scheme shall be employed.

It is apparent that, from the perspective of regulatory approach, betweenprinciples-based and rules-based, the CBRC has pursued a rules-based regulatoryapproach. The above Guidelines on Fixed Assets Loans (2009) is a typical example of howcommand-control regulation has been applied in the regulatory process.

Although a principles-based approach to regulation may not work well for emergingmarkets (Ping, 2011), in China, while command-control regulation is dominant,principles-based regulation approach by the CBRC has emerged partly in response toregulatory demand for innovation (CBRC, 2007a, p. 58). At the risk of oversimplification,I will try to illustrate how those two approaches have been adopted and furthermore,how command-control and self regulation are both evident in this combined approach.

From 2007, the CBRC required that banks adopt an internal ratings-based (IRB)approach to determine credit risk (CBRC, 2008, p. 72). Furthermore, banks were alsoencouraged to apply an advanced IRB approach (CBRC, 2007b). In determining marketrisk, the CBRC suggests that a standardized approach shall be adopted among commercialbanks[28]. The internal models approach, which is perceived to be more advanced, wasintroduced to commercial banks with complex businesses to address market risk[29].Although there are three approaches specified available to gauge operational risk[30], theCBRC has not expressed a preference for a specified approach in its documents. It directsbanks to choose the most approach most appropriate to their specific circumstances inmanaging operational risk[31]. While ensuring an appropriate code of banking practice inthis regard, the CBRC leaves the precise choice to banks as to which approach best fitstheir circumstances. This gives the regulated banks flexibility in choosing and developingmost desirable approach in controlling credit risk.

Another example to illustrate the gradual application of self-regulation, througha principles-based approach, lies in derivatives business. In 2006, the CBRCpromulgated Implementation Measures on Administrative Licensing Items Relatingto Foreign Financial Institutions (2006). Chapter 3 of this laid down implementationmeasures in relation to requirements and procedures for conducting derivativesbusiness. Despite the fact that the scope of derivatives business was not addressed,Sections 98 and 99 provided guidelines for foreign banks to apply when expanding theirderivatives business. This was achieved by submitting a specific application to theCBRC. The CBRC started to approve some derivatives business relating to equities andcommodities on a case-by-case basis (Han, 2007). In addition, the regulation of derivativebusiness was also addressed by the Guidelines on Financial Innovation of CommercialBanks (2006). Instead of well-elaborated rules, this set out general principles governingfinancial innovations like derivatives; know your business, know your risks, know yourcustomers, and know your counter-parties[32]. The regulatory intention was to meet theneeds of the economy[33]. As a result, although subject to the regulator’s approvaland oversight, derivative products development and marketing were largely

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a self-administered process. Foreign banks subsequently embarked upon derivativebusiness and it was a key source of revenue for foreign banks trading in China[34].

The final tier is the CBRC’s Window Guidance measures.China’s Window Guidancewas largely modelled on Japanese practice which existed until the early 1990s[35].Previously, the study of Window Guidance in China has been focused on the monetarypolicy regulator, PBoC as the role of Window Guidance predominantly relates to creditcontrol. To date the CBRC has been largely neglected as another employer of WindowGuidance measures. However, the CBRC also employs Window Guidance as a powerfulregulatory initiative to keep banks in line with its regulatory goals. Although itis not legally enforceable, the CBRC claims it as a suasive regulatory approach[36].The purpose of Window Guidance is to inform banks of the CBRC’s regulatoryintentions, prepare guiding opinions, or signal risks to financial institutions[36].Window Guidance is usually in the form of verbal or telephone communications, but isnever in writing.

At the time it was created, the CBRC used Window Guidance to advise 11 commercialbanks to limit lending to certain sectors (Geiger, 2008). In 2009, to avoid bank loansentering into the real estate market and the capital market, the CBRC issued a notice on“loans management” and stepped up Window Guidance measures in this regard(Xinhua, 2009). In accordance with this Notice, banks were required to control loan size.Window Guidance occurred in relation to what was the proper “loan size” for a specificbank. It consisted of verbal communications between the regulatory officer from theCBRC and the compliance office at a bank. Standards for “a proper loan size” differedfrom bank to bank due to their own asset size and loan-to-deposit ratio. Under theoverarching principles, the CBRC provided various detailed Window Guidancemeasures to different banking institutions according to their characteristics(CBRC, 2008, p. 53). The extent of reliance on Window Guidance measures is quiteextensive, encompassing banks activities in capital markets, subordinated bondsissuance, overseas investments, loans related to real estate, high polluting, and, energyconsuming and resources dependent industries (CBRC, 2008, p. 64). In 2007, WindowGuidance measures were employed to increase loans to pork producers as pork was inshort supply[37].

As illustrated, Window Guidance is a combination of principles-based andrules-based approaches. Particular regulatory objectives are integrated in the form ofguidance, notice and rules, and these are open-ended in assisting the applicationof specific regulatory objectives in accordance with the different circumstancesof individual banks. Open-ended rules are subject to the interpretation of the regulatorand allow the regulator to respond to constantly changing conditions without the needfor formal frequent amendments.

As implemented by the CBRC, Window Guidance is a flexible regulatory tool, and isnot constrained by time and geography. Window Guidance measures enable regulatorsto act in a prompt manner to changing circumstances[38]. Adapting to changingeconomic conditions in contemporary China has been a major challenge for regulators.The CBRC affiliates in local areas apply specific rules as required by local needs.In banking sector, one-size-fits-all rules are unable to account for the ways in which riskmanifests itself in individual regulated entities (Bamberger, 2006). More importantly,in an economy like China’s with many markets in which the population of theregulated banks is vast, and the dynamics of individual banks vary dramatically,

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Window Guidance allows for a tailored approach to regulating different categories ofbanks in terms of size and complexity[39]. For instance, some foreign banks in Chinahold complex derivative products whereas some Chinese banks still primarily focus onloan-based basic banking products. As a result, the CBRC is able to devote its regulatoryresources to a “differentiated” approach in accordance with varying degrees ofregulatory criteria of the regulated entities. Overall, Window Guidance measuresprovide the regulator with constant interaction with banks, provide the regulators roomfor regulatory discretion; and also provide regulators an avenue to execute politicalconcerns, and to “effectuate policy considerations” (Zhi, 2011).

Although Window Guidance is claimed to be “suasive” in nature and consequentlydoes not incur any legal or regulatory consequences if it is not adhered to, the efficacy ofthese measures is evident in the fact that they have effectively determined the loan growthof individual banks as directed by the regulator (The Banker, 2010). The implementationof Window Guidance has heavy weighting for individual banks in the CBRC’s scoringsystem which determines banks’ potential eligibilities for banking products and business.On the other hand, as Window Guidance does not contain explicit penalty sanctions,it may well undermine the effectiveness of those measures in implementation. WindowGuidance does not always deter banks’ undesirable behaviour. Banks could still extendtheir credit beyond their loan limits and to industries like real estate which have beenprohibited by regulators (National Audit Office of the People’s Republic of China, 2009).

Window Guidance measures can also be problematic in implementation. They createdifficulties for new market entrants, especially foreign banks in understanding China’sregulatory culture. The challenge confronting foreign banks comprehending WindowGuidance is apparent. As purely verbally transferable regulatory measures, the contentof Window Guidance measures is solely obtained and possessed by compliance officers.It also made it difficult for local compliance officers to convey the CBRC’s WindowGuidance Measures to their off-shore head offices. When pressed for the source of theguidance, local officers are unable to provide written authority and are driven back totheir own understanding or interpretation of the verbal guidance. Foreign head offices areoften not satisfied with the lack of an officially verifiable version of the guidance. Theytend to see this as a lack of transparency. The further implementation of those measures isdependent on compliance officers and their discretion where their interpretation andclarification could dictate regulatory outcomes. The question could also arise whetherindividual compliance officers’ interpretations are consistent with the regulatoryintention of the regulator. Certainty of regulatory initiatives could be lost in transmissionand the exclusive interpretation of individual regulatory officers. Window Guidance alsoinevitably increases banks’ compliance cost. A compliance office in a foreign bank mayhave five or six conversations a day on compliance issues (PwC, 2010, p. 64).

From the above, it is clear that Window Guidance falls short of clarity in regulatoryexpectations, and compromises certainty in implementation, the flexibility of which,however, provides the CBRC adaptability in implementation. In utilizing the meritsof regulatory principles, at the same time, the CBRC guides individual banksby providing them with descriptive rules in an informal but resolute manner.Given quickly changing social, and economic circumstances, the flexibility of WindowGuidance measures is prized by the CBRC in meeting contemporary regulatory needs.

As the above examples illustrate, despite dominance of traditionalcommand-and-control regulation through rules-based regulation, principles based

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regulation has been gradually incorporated into the regulatory process to promoteinnovation and productivity among banks in the banking sector (CBRC, 2007a, p. 13).Regulatory means of command-and-control, relying more on detailed prescription andpenalty, are undoubtedly present, but there is also a degree of self-regulation within moregeneral and looser control. This combination shows China’s regulatory continuity withthe past of a command economy in which the government is in firm control, imposingfixed rules with clearly articulated consequences in the event of non-conformity. Thishas assured certainty and compliance in banking regulation for various participants.The regulatory measures also have responded to new economic circumstances and havetended to move away from the traditional command-control to a certain degree ofreliance on principles based regulation. Through delegating some interpretative powerto the regulated entities and external third parties, it is evident that principles basedregulation has emerged as a complement to command-and-control regulation.

Exceptional occurances, like the GFC had a considerable bearing on China’s bankingregulatory trajectory. The GFC hit both the UK and the USA, representatives of aprinciples-based and rules-based regulation, respectively, hard and both jurisdictionssuffered severe banking regulatory consequences. The GFC revealed shortcomingsinherent within those two approaches. To overcome these regulatory detriments,Chinese regulators have tightened regulatory control and regulatory adjustments havebeen made accordingly. Regulatory measures have been moved back toward morecommand-control regulation. In the case of derivative business banks are confrontedwith more stringent risk management requirements[40]. Banks have to formulate asound assessment system to evaluate the suitability of derivatives products on aone-by-one basis for each client[41]. The CBRC precludes the involvement of any salespersonnel of any offshore entities in derivative business[42]. Foreign banks areprohibited from marketing their offshore derivative products to onshore clients. As astark contrast to the previous principles-based approach addressing derivativesbusiness, the CBRC was taking a more rigid stand and acting forcefully by imposed fixedstandards regulating derivatives business after the GFC.

V. ConclusionA decade into banking sector reform in China following the formation of the CBRC,we find that the rationale and principles of banking regulation are not fundamentallydifferent from developed jurisdictions. However, while preserving common regulatoryobjectives and goals, given the country specific nature of banking regulation, Chinesebanking regulation also inevitably possesses unique regulatory features. This is anindication of historical continuity, but also reflective of social, economic, and politicalconditions in contemporary China. In addition to express objectives, powers, andfunctions contained in laws and regulations, it is necessary to recognise the existenceof a body of implicit goals pursued by the CBRC, and unique means acquired bythe CBRC in undertaking its banking supervision in China.

Notes

1. Decision on Chinese Banking Regulatory Committee in charge of supervisory and regulatoryresponsibility 2003.

2. S 1, Laws of People’s Republic of China Banking Regulation 2003.

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3. Ss 1, 2 Laws of People’s Republic of China People’s Bank of China 1995.

4. S4 Laws of People’s Republic of China People’s Bank of China 2003.

5. 8th National People’s Congress Committee, Announcement of Administrationof Governmental Agencies, 1993.

6. S 5, Laws of People’s Republic of China Banking Regulation 2003.

7. S 3, Rules for Implementing the Regulations of the People’s Republic of Chinaon Administration of Foreign-Funded Banks 2006.

8. S 39, Laws of Commercial Banks in People’s Republic of China 2003.

9. Notice on Implementing Rules of Regulations of the People’s Republic of Chinaon Administration of Foreign-Funded Banks 2006.

10. Guidance on new regulatory standards 2011.

11. S 46, Rules for Implementing the Regulations of the People’s Republic of Chinaon Administration of Foreign-Funded Banks 2006.

12. S15 Laws of People’s Republic of China banking regulation 2003. In some jurisdictions,regulators’ rule-making power is confined to implementing statutory objectives. See ins2 Financial Services and Markets Act 2000 (UK).

13. Rules on Auto Loans 2004.

14. Guidance on the Directors’ Performance Appraisal of Commercial Banks 2010.

15. Ss 31 32, Guidance on the Directors’ Performance Appraisal of Commercial Banks 2010.

16. Notice on operational risk control 2005.

17. Dai Xiang Rong, “Gaijin Jinrong fuwu Zhichi Guoqi Gaige he Fazhan, improve financialservices supporting SOE reform”, speech delivered at the Zai Zhongguo Renming yinhangFenhang Hangzhang Jidu Liehui Shang jiang hua, Meeting of Branch Manangers of thePeople’s Bank of China.

18. The CBRC promulgated nine pieces of supportive legislation, ranging from innovationto credit extension, particularly addressing rural financial institutions.

19. Financial support for the agricultural development and its production 2008.

20. CBRC, public notice of the CBRC on further opening up China’s banking industry (2005).In 2005, another five western and northern cities were opened to foreign-funded financialinstitutions for this purpose. For instance, an application by a foreign bank to open a branchin the West would be granted quickly, as opposed to an application to open a branch in theEast (CBRC, 2009, p. 61).

21. Notice of China Banking Regulatory Commission on expanding the pilot program oflowering market entry threshold for setting up rural banking institutions 2007 and CBRC(2008, p. 122).

22. Pilot rules on county banks 2007.

23. Rules for implementing the regulations of the People’s Republic of China on Administrationof Foreign-Funded Banks 2006.

24. Resolution concerning the strengthening legal interpretative work 1981.

25. S 11 Fa Lu Gong Zuo Gui Ding rules on the China banking regulatory commissionrule-making work 2005.

26. Only one foreign banks was licensed to local incorporation (CBRC, 2010, p. 38).

27. Guidelines on fixed assets loans 2009.

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28. S 32 Rules governing capital adequacy of commercial banks 2004.

29. SS 19.20 Guidelines on market risk management of commercial banks 2005.

30. The basic indicator approach, the standardised approach and advanced measurementapproaches.

31. S 13 Guidelines on market risk management of commercial banks 2005.

32. Ss 14-17 Guidelines on financial innovation of commercial banks 2006.

33. S 3 Guidelines on financial innovation of commercial banks 2006.

34. Note that derivative business was almost shut down in the wake of GFC (PwC, 2010, p. 30).

35. Window guidance played a major role in Japan in the past and its effectiveness wasundermined by financial liberalization in the 1980s (Fukumoto, 2010).

36. Regulatory measures in regulating commercial banks Gu Fen Zhi Shang Ye Yin Hang JianGuan Gong Zuo Zhong Ji Zhong Zhuan Men Jian Guan Shou Duan Ji Qi Yun Zuo QingKuang de Jie Shao.

37. Guidelines on supporting pork production 2007.

38. Regulatory measures in regulating commercial banks Gu Fen Zhi Shang Ye Yin Hang JianGuan Gong Zuo Zhong Ji Zhong Zhuan Men Jian Guan Shou Duan Ji Qi Yun Zuo QingKuang de Jie Shao.

39. In China, some banks are sophisticated in risk management whereas some banksexperiencing difficulties in establishing risk management procedures (Ping, 2011, p. 6).

40. Notice on further strengthening the risk management of derivative product transactionsbetween banking financial institutions and institutional clients 2009.

41. S 2 Notice on further strengthening the risk management of derivative product transactionsbetween banking financial institutions and institutional clients 2009.

42. S 12 Notice on further strengthening the risk management of derivative product transactionsbetween banking financial institutions and institutional clients 2009.

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Corresponding authorWei Ping He can be contacted at: [email protected]

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