Ninth Symposium on Building the Financial System of the 21st Century China Development Reform Foundation Harvard Program on International Financial Systems Beijing, China, September 14-16, 2012 Topic 2: Financial Regulation and Financial Innovation Panel Remarks By Andrew Sheng 1 President Fung Global Institute I am very honoured to be invited by Lu Mai and Hal Scott to join for my first time, the US-China Symposium on Building the Financial System of the 21st century, a subject of a major research study of the Fung Global Institute.
Some of you may be aware that Anthony Neoh (one of the founders of this Forum), Laura Cha and I are amongst the first people from outside China to be invited to work inside the Chinese bureaucracy. What we have learnt is that there is still considerable gap in understanding the complexities of China and explaining them to a non-Chinese audience. Winston Churchill famously said that the English people and the American people are divided by the same language.
Similarly, those of us who speak Chinese find that understanding China is not easy unless you understand its history and complex culture, including the nuances in use of language and its syntax. As former Chairman of the Hong Kong Securities and Futures Commission, I relied very much on Harvard regulatory Professor Malcolm Sparrow’s maxim on the regulatory craft: “Pick Important Problems, Fix Them and Tell Everyone”. After working in China, I learnt that the Chinese approach to regulation is to use Chairman Mao’s dictum, “Identify the Principal Contradiction, Understand that Contradiction, and Deal with it.
” Why is global and national regulation in contradiction? We talk about global imbalances, but these imbalances are fundamentally major contradictions between benefits and risks. Our rapporteur has identified that there is need for a balance between financial regulation and financial innovation, between market efficiency versus market stability, between principles-based regulation and rules-based regulation and so on. These are all contradictions that require 1 This is an adapted note of views expressed at the Symposium.
The views expressed here are entirely personal to the author and not necessarily those of the Fung Global Institute. 1 trade-offs that are more in the realm of politics than pure technical, professional issues. This inherent contradiction in global finance is best illustrated by Bank of England Governor Mervyn King’s dictum that “Banking is Global in Life, but National in Death”, meaning that regulation is largely enforced nationally, but financial institutions roam the world as their market, but if they fail, losses are settled nationally.
But national regulators had not realized that these nationalbased banks have large leverage recorded off-balance sheet (below the line) and off-shore (in tax free specialized investment vehicles). They still cannot deal with this without some form of enforceable global regulatory structure. There is general consensus that the primary cause of all financial crises, including the most recent one, is over-consumption financed by over-leverage. On global imbalance is surely over regulation and under-enforcement.
This was the criticism of Asian financial regulation before the Asian crisis, but this seems to be the trend for advanced financial markets as well. Regulation is best enforced through tough enforcement on simple rules/principles that are easy to understand, easy to implement and comply, and easy to enforce. The present solutions and reforms have added complexity to complexity 2. The new rules are difficult to understand, costly to implement and it is still unclear whether they serve to reduce systemic risks.
One theme that was brought up was the growing complexity of regulation and that market abuses arose because products and institutions became too complex to understand, manage and regulate. In fact, when thing get too complex, crises simplify things through Schumpeterian creative destruction. This was what happened to Asia during the Asian financial crisis 1997/99. This depends on the philosophy behind the regulatory framework. In the West, the typical sequence is regulation and then development. This is because the 2 The problem with bank finance today is that it does not serve the real economy. Who is really to blame?
My personal view is that global financial regulators and policy makers believed too much the free market theory that became ideology. Mea culpa, as I also thought that market competition would deliver superior results than micro-regulation. In the 1980s, freeing price competition as a matter of regulatory policy reduced interest margins and securities commissions. When banks and securities houses could not make money as agents, they turned instead to expanding their book (through derivative leverage) and also proprietary trading for their own interests, taking both huge leverage and systemic risks.
Post-crisis, the financial markets have become even more concentrated in the West, and their entry into Asian markets will pose even more competition in the future. What is to be done? See Andrew Haldane, “The Dog and the Frisbee”, Jackson Hole Conference, Bank of England, August 2012, available at www. bankofengland. gov. uk. 2 basic Western legal framework is common law, supplemented by constitutional and administrative law, which changes the law and regulations through the legislature. But in China, this process has been reversed, because in practice, the Chinese allow development first, followed by changes in the law and regulations.
There are two fundamental reasons for this difference in approach. In the West, common law formed the foundations of a mature market economy, with strong mature institutions. Hence, reforms come after legal change, such as the DoddFranks legislation. However, the post-crisis legislative changes have become controversial, because as Chicago Law and Economics Professor Richard Posner suggested, the law reforms came before the full analysis of the causes of the crisis by the Financial Crisis Inquiry Commission.
Indeed, Posner suggested that the crisis could have been prevented by more stringent enforcement before the crisis, rather than more stringent regulation after the crisis. In the Chinese case, because market institutions and legislation are still immature and under-developed, there is considerable reservation in using the Western approach of law first, market operations later. There are three problems with using the Western approach in China: Second, how does one write rules for an unknown unknown future, particularly since there has been never such development on the scale of 1.
3 billion people moving from a socialist system to market system in 30 years? One lesson from recent Chinese reforms has been: ???? ,? ??? (everything stops with (over) regulation, but if there is no regulation there is chaos). Third, how do you write rules on financial innovation, when there are generally no rules in the West on this other than “Caveat Emptor”? Chinese financial institutions are still learning and copying Western business models and their due processes and due discipline in client service and client suitability are still immature.
First, since the market itself is developing very fast, no rules can apply for all time, so the Chinese use administrative guidelines to see how they fit, before changing them into law when the market behaviour becomes more “settled”. Let me illustrate the difference in approach with respect to the balance or contradiction between financial innovation and regulation. In this Symposium, the father of financial futures, Leo Melamed, gave an excellent talk on “Innovate, Adapt or Die”. As you will recall, former Fed Chairman Paul Volcker famously said that the best financial innovation in the last 30 years was the ATM machine.
Technological innovation poses tremendous game changes to the financial sector, because the biggest network and potential payment system in China today is China Mobile, which can pose tremendous competition to Chinese banks 3 with new payment and credit applications. ??? “ It was the only way to force Chinese banks to realize that they have responsibility in client suitability – the products must suit the buyers. Allow me to illustrate the Chinese and Western dilemma in dealing with the unknown unknowns.
The Anglo-Saxon approach to innovation is to not to fear change, because the neoclassical paradigm is an ideal that reverts back to equilibrium and stability. Because of their (sometime chaotic) history, Chinese authorities are more cautious, preferring to “cross the river by feeling the stones”. In practice, this means moving cautiously and methodically by experimenting, experiencing, sharing, collaborating and only when the next stepping stone is firm, do they extrapolate the lessons and widen the experiment nation-wide. In Western terminology, the Chinese way of “crossing the river by feeling the stones” is not random.
There is method in the “madness”. The Chinese regulators are struggling with how to promote innovation and yet preserve stability. The first guidelines on financial innovation carried the dictum, “Buyer Beware, but Seller must have responsibilities – ???? ;?? The challenge of Building the Financial System of the 21st Century is how to induce finance to serve the real economy? Building the Financial System of the 21st Century The fundamental difference in philosophy over financial reform is that finance must both help the real economy and its innovation-experimentation needs to be continuously aligned with the real sector needs.
The divergence in philosophy became clear when a subprime crisis in the housing sector of $150 billion escalated to global fiscal rescue, support and guarantee amounting to $14 trillion, roughly one quarter of the world’s GDP 3. Finance is a service industry, important because it is trustee to public savings and allocator of credit to real sector users. The Fung Global Institute did a study of where the current advanced country bank profits are made. Trade finance, mergers and acquisitions and corporate credit used to be the main profit centers of banks in the 1980s.
Today, after Basel III requirements, the return on equity (ROE) on trade finance is less than 5 percent, whereas by contrast, the ROE on proprietary trading in stocks and foreign exchange is between 15 percent and 25 percent. It is clear that banks will continue to do proprietary trading and present Basel III reforms have not address the incentive issues that lead to systemic instability. Chinese banks and financial institutions today realize that they need a new growth and profit model, especially when interest rate margins will be squeezed from greater competition.
How to achieve profits and market access and stability will be an important dialogue between industry and the regulators. 4 3 See Financial Crisis Inquiry Report (2011), now at Stanford University website. This is a dialogue that remains contentious outside China. China and US dialogue on many issues are necessary because both countries share universal objectives of People, Planet and Profits – the need to have social inclusion, environmental sustainability and growth and profits.
Both countries are highly complex economies with deep social and cultural differences that need to be bridged. A better understanding through the use of common dialogue and syntax would certainly help move towards mutuality of interests in global stability, especially in the financial field, which is the topic of discussion today. I want to thank the organizers for this opportunity to present some views on the bridging of cultures in the financial field. Beijing and Hong Kong, 16 September 10212