Junbo Xiang: Improve the legal system to prevent financial risks
Speech by Mr Junbo Xiang, Deputy Governor of the People's Bank of China, at the "2005 High-level
Forum of China's Financial Reform", Shanghai, 26 April 2005.
* * *
Ladies and Gentlemen:
It's a pleasure to attend this high-level forum of China's financial reform, sponsored by the Financial
Research Institute, Development Research Center of the State Council. In my view, the theme of this
forum, "Financial Innovation and Risk Prevention", is of great significance. Innovation is the
inexhaustible impetus for the development of financial sector. The rise and decline of financial
development in the 20th century can be viewed as a history of innovations one after another. In 1950s,
the institutional investor sprang up with the establishment of modern pension funds. In 1960s, credit
card appeared. In 1970s, Eurodollar and Eurobond came into being. And since 1980s, in a new round
of financial liberalization, various financial derivatives and cross-financial sector products were
introduced in the market. Of course, due to the uncertainty of innovations, while the innovations on
financial system, institutions, market, products and service boosting the growth of financial sector and
profits of financial institutions, new financial risks also emerged. China is also confronted with such
problems. Therefore, how to deal with financial innovation and risk prevention to keep a balance
between them poses a big challenge for supervisory authorities and financial institutions.
Financial legal system not only provides regulation for financial institutions, financial business
participants and their legal relationship, but also improves the self-discipline of financial supervisors.
The main target of financial legislation is to adjust the legal relationship among financial supervisors,
institutions and customers, protect customers' legitimate rights, and strengthen the supervision on
those areas where market plays a leading role in coordinating financial supervision and market
selfdiscipline. Where there is market, there is risk, which is also the same for the financial sector. Thus,
the purpose of financial legislation is not to wipe out all risks, but to control it in a certain scale that can
be handled by the supervisors and absorbed by the financial institutions. Viewing from this aspect, the
establishment and enforcement of financial legal system are indispensable for preventing, controlling
and dissolving financial risks. On today's occasion, I would like to share with you my observations
about the prevention of financial risks in China in the broad context of financial innovation from the
aspect of financial legislation.
I. Current status of financial risks in China
Financial risk refers to the possibility that a financial institution suffers from a loss of funds, property or
reputation due to changes in macroeconomic policy environment, market situation, exchange rate or
mismanagement. And there are various kinds of risks, such as operational risk, institutional risk,
macro-risk, micro-risk, etc. According to the Basel Core Principles on Effective Banking Supervision,
the financial risks can be classified into eight categories, including credit risk, market risk, operational
risk, liquidity risk, legal risk, etc. Judged by each of these categories, China's financial risks have
broadly reduced in recent years. However, potential risks still exist in the financial sector. In my
opinion, there are obviously three kinds of risks in China's financial system.
First, credit risk remains the major risk in China's financial industry. Loan and investment are the main
business of financial institutions, which requires financial institutions to make appropriate assessment
on the credit status of the lender and receiver of investment. However, due to the information
asymmetry, their assessment cannot always be correct, and the credit standing of the lender or the
receiver of investment may decline due to various factors. Therefore, a major risk financial institutions
facing is the lender's default risk, i.e., credit risk. During business operation, if financial institutions fail
to timely identify the problematic financial asset, set up special loan loss provisions to write off bad
loans, or stop accruing relevant interests, there will be serious problems ahead.
According to the balance sheet, asset quality of China's banking institutions has been enhanced in
recent years, with the absolute amount and ratio of non-performing loans declining, which could be
attributed to the supervisors strengthening regulation and the financial institutions deepening reform to
improve internal management. But we have to be mindful of the fact that the decline of non-performing
loans is also partly a result of economic expansion, in which bank loans increased dramatically. For
example, in 2003 and 2004, new loans in all financial institutions amounted to RMB2740 billion and
2260 billion yuan respectively. Besides, compared with the international banking standard, China's
major commercial banks still have a relatively high NPL ratio of 13.2% in 2004, and the CAR of most
commercial banks have not met the legal requirement of 8%.
While assessing the credit risks of the financial institutions, one of the important points is the large
increase of loans in the real estate sector. The development of China's real estate sector is closely
related to the housing reform, which started in the end of last century and finished in recent years.
Housing mortgage loans emerged as a new business after the start of housing reform. Since the real
estate lending has a relatively stable income compared with traditional business, it is actively
developed by banks. Therefore, it's reasonable that real estate loans increase fast. However, real
estate lending in China is relatively a new business that has not been tested in economic cycle
changes. It has just started a few years ago and there is no available data on the medium and
longterm default ratio. Besides, the Chinese economy is in a new expansion period, and the prosperity of
the economy partly covers the potential risks involved in real estate lending. The economic prosperity
changes as the tide, and once the pace of the economy slows down, the default ratio of real estate
lending will probably increase, so we cannot be too optimistic. In this field, we should learn from the
lessons of Japanese real estate bubble. After the bubble burst, their bad loans increased dramatically
and bond market was also affected, in addition to the revaluation of yen, which push the Japanese
economy into a decade of recession. As a developing country, China always stresses the sustainable,
steady, fast, and healthy development of economy. If we failed in this field, the economy would suffer
a huge loss, even if the recession may only last for a few years.
Not only banks but also securities companies face high credit risks, with most securities companies
suffering low asset quality. Recently, many of the insolvent ones have been taken over, and the
Central Bank has to provide central bank lending to pay individual creditors of these companies. Thus,
we cannot relax our vigilance on credit risk in the financial sector, for it remains one of the major risks
in the financial industry.
Second, the frequent occurrence of operational risk is one of the outstanding characteristics in the
financial industry. According to the definitions made by the Basel Committee, financial institutions face
two kinds of operational risks: one refers to the losses resulted from the failure of information and
technology system or other disasters; and the other refers to the losses resulted from the failure of
internal control and the failure in responding promptly to various mistakes, frauds, misuse of power or
various moral hazards. In terms of the exposed operational risks in recent years in the financial
industry, the failure of internal control constitutes the major source of operational risks. In particular,
the resulted loss mainly comes from corruption of the senior management, irregularities of the staff,
and financial frauds.
Recently, many cases have been detected in the financial sector, especially in commercial banks,
which to some degree could be attributed to the deepening of banks' internal reform, exposing the
deeply hidden cases. Even though, it indicates that the operational risk is relatively high in China's
financial sector, which is not in line with our strategic target to establish a modern financial system.
The continuously exposed operational risks not only make financial institutions suffer big losses, but
also impair their reputation. For example, the latest exposed major cases in financial system have
negative impact on the financial industry's reputation both at home and abroad.
Third, cross-market and cross-sector financial risks become new unstable elements in China's
financial industry. In recent years, with the restructuring of the financial industry and the increasing
consolidation of financial business, cross-market and cross-sector financial risks becomes a new
element affecting the stability of the financial system. Nowadays, such risks are shown in two aspects.
First, various financial-holding companies have emerged, such as the CITIC. Such financial-holding
companies provide both banking products and securities products. However, effective and
consolidated supervision is lacked, leading to many potential risks, such as infringement of consumer
(investor)'s interests, connected trading and the transmission of financial risks from one subsidiary to
other companies or to the whole group. Second, banks, trust companies, securities firms and
insurance companies are developing kinds of cross-currency, cross-financing, and cross-market
products and instruments in an effort to dismantle business segregation, such as the joint entrusted
loan business and wealth management business provided by banks, which involve potential risks.
Through the PBC's recent experience in preventing and dealing with systematic financial risks, we
have found that cross-market financial risks are on the rise. Theses risks are more prominent in the
capital operation of financial holding companies or sub-financial holding companies that were originally
industrial companies. As such companies have business in both the industrial sector and financial
sector, which involves banks, securities companies, trust companies and insurance companies, their
capital operation is characterized by a financing chain of "Financing-M&A-Listing-Re-M&A-
Re-financing". Huge operational risks are hidden in the chain. Given that both ends are "financing",
financial institutions will become the biggest victim if the chain breaks. For instance, the recent crisis
with a number of associated listed companies hurt numerous stock investors, shook the stock market,
and inflicted heavy losses on relevant financial institutions. The stability of the entire financial system
is also threatened.
It goes without saying that financial innovation has become an effective means to seek greater
prospect, return and competitiveness by financial institutions. Nonetheless, the external environment
and the business model of financial institutions are undergoing sea changes, and
financial-innovationrelated new products and businesses could transfer risks among financial institutions. The entrusted
wealth management business, which is actively promoted by banks, securities companies, trust
companies and insurance companies, deserves our special attention. Despite the different names
given to the business by different financial institutions and the different rules of operation, the fact that
the so-called "wealth" is invested in the stock market, foreign exchange market, and inter-bank bond
market suggests that this business/product is a cross-market financial product. We have learned from
some recent crises in high-risk securities companies that the huge losses incurred from entrusted
wealth management business played a vital part in the insolvency of such companies. As active
players in the money market, securities companies will undoubtedly transfer their own risks to other
market participants. We are by no means against the entrusted wealth management business, though.
We are merely suggesting that the financial risks associated with cross-market financial products have
surfaced.
II. The causes of China's financial risks in perspective of legal framework for the
financial sector
The high risks embedded in China's financial system are the result of various problems in the national
economy over a protracted period. The transition of the economic system, the change of the social
environment, the rigidity of the financial system, the inadequacy of financial supervision and the
defects in the legal framework for the financial sector are among the causes of the high risks in
China's financial system. Scholars and government officials have done numerous studies in those
regards. Here, I would like to discuss the reasons underlying these risks, especially the three major
risks, in China's financial sector from the legal point of view.
As is known to all, the legal framework is in essence a tool to regulate the relationship among financial
supervisors, financial institutions and investors in financial products. In addition to regulating the legal
relationship, the legal framework for the financial sector has many other functions, including
punishment, encouragement, inhibition and guidance. In economic terms, it could be translated into
predictable interest or loss. A large number of rules and regulations for the financial sector have been
Law
formulated since 1979, when China adopted the reform and opening-up policy. Such rules as the
of the People's Republic of China on the People' s Bank of China, the Commercial Banking Law of the
People's Republic of Chin, Law of the People's Republic of China on Banking Regulation and
the
Supervision, the Securities Law of the People's Republic of China, and the Insurance Law of the
People's Republic of China
which regulate financial supervision, financial institutions and their
behaviors, have formed the fundamental legal framework for the financial sector. The Law on
Administrative Penalty, Law on Administrative Appeal, Law on Administrative License
the and the are
designed to regulate the administrative behavior of financial supervisors. In addition, the Law on
Negotiable Instruments, Guarantee Law, Company Law
the and the are designed to regulate civil and
commercial relations.
However, we should be aware that the existing financial legal rules were established in the
development of emerging markets and the transitional period of economy. With the deepening reform
of China's financial system, the accelerating opening-up and the enhancing innovation of the financial
sector, the existing legal framework can hardly satisfy the changing requirement of the financial sector.
Especially, we need to make an overview of the basic legal environment that our financial sector relies
on and improve the research on laws for financial innovation (including system innovation, institution
innovation and product innovation). Currently, three kinds of financial risks stand high in China's
financial system, which is to some degree related to the inadequacy and incompatibility of our legal
rules.
First, the lack of regulations on credit reporting hindered the development of credit reporting industry
and the evaluation on the credit status of the borrowers by the financial institutions. Generally
speaking, credit reporting refers to the collection, evaluation and sales of market participants' credit
information, and the credit information system is established to address the information asymmetry in
financial transactions. With the economic activities being more and more complicated, the financial
institutions increasingly rely on credit reporting department or social credit reporting agency to
enhance the investigation and analysis of the credit status of borrowers. The establishment of credit
information system has not been put on agenda in China until recent years. It is a task that should be
strongly supported by laws since corporate and individual credit information collection involve the
privacy of citizens and commercial secrets of enterprises. However, there is no relevant rules for credit
reporting in the existing legal framework, and hence the credit reporting agencies can not collect and
disclose information according to laws and the interests of the enterprises and individuals can hardly
be safeguarded, which has hindered the healthy development of credit reporting industry. Failure of
the financial institutions to timely detects irregularities in financial transactions such as duplicate
frauds, repetitive mortgage with the same assets and connected guarantee, etc. may cause great
asset loss.
Second, the underdeveloped enterprise insolvency law makes it difficult for financial institutions to
protect their assets. The protection of financial institution creditors under the enterprise insolvency
legal framework has a direct impact on the safety of the financial institutions' assets. The existing laws
Provisional Enterprise Insolvency Law
governing enterprise insolvency mainly include the applied to
the state-owned enterprises, Chapter XIX (Debt repayment procedures for the insolvency of corporate
Civil Procedure Law
legal entities) in the applied to other enterprises, and a series of judicial
explanations promulgated by the Supreme People's Court. However, these laws have not adequately
protected the rights of creditors. In terms of the building of insolvency legal system, the bankruptcy
administrator system commonly adopted as an international practice has not been established in
China, and the current bankruptcy liquidation system often ignores the interests of creditors in
liquidation. In terms of the bankruptcy procedures, relevant rules on the administration and acceptance
of the insolvency cases, creditors' meeting, and supervision system are not complete in the existing
legal system, which further weakens the protection of creditors' rights by the law. As the last resort to
protect the claims of financial institutions, if the insolvency law fails to fully protect the interests of the
creditors, non-performing loans and credit risks will probably accumulate in financial institutions.
Enterprise Insolvency Law
Currently, legislation of the new has entered a critical stage. Compared
with the existing law, the new one (the second draft) on the one hand extends its application by
including all the corporate legal entities under its umbrella, and enriches the provisions on insolvency
procedures on the other hand by improving the protection of creditors' rights in every aspect. However,
defects remain in the draft law concerning the determination of repayment priority of claims and criteria
of insolvency, two focal points that are closely related to the protection of creditors' rights. Regarding
repayment priority of claims, priority is given to employee entitlements over secured debts. Regarding
the insolvency criteria, the draft law lists enterprises failing to repay due debts and failing to repay all
debts with their assets (in evident insolvency) both as tests for insolvency, which will undoubtedly
impose negative impact on the protection of the claims of financial institutions.
Giving priority to employee entitlements over secured debts, which increases the difficulties for the
recourse of banking claims and lowers the recovery ratio of non-performing assets, will weaken the
ability of financial institutions to dispose of non-performing assets and lead to financial risks. In
addition, underprotection of the secured debts will damage the basic principles of laws and the
confidence of economic entities in the security system as the last protection. Law also represents a
faith. Without a confidence in the law, even the most prudent and systematic law will become a mere
scrap of paper. However, the excessively strict tests of insolvency make creditors unable to apply for
effecting insolvency of the debtors timely and effectively. Taking "inability to repay all debts with assets
or in evident insolvency" as the criteria will prevent the enterprises from entering the bankruptcy
procedures until they become absolutely insavable. Under this circumstance, the opportunities to
restructure or reconcile the insolvent enterprises will be missed, resulting in a failure to provide
maximum protection for the creditor's rights.
Third, weakness in criminal liability investigation for financial frauds and irregularities exposes financial
institutions to operational risks. The frequent occurrence of operational risks is one of the big problems
for China's financial sector. In particular, financial frauds and irregularities have caused great losses to
financial institutions. Based on the analysis of recent cases, financial frauds in China could be divided
into two categories: one is to provide false information for the purpose of illegal possession, such as
frauds in letter of credit or negotiable instruments; the other is to swindle money by deliberately
providing false financial information to benefit the enterprises instead of illegal possession. In the latter
case, the use of the funds stated by the loan applicant is true; however, the applicant may deliberately
submit false information to the financial institutions that can mislead the banks' decision in credit
authorization. Currently, most of the frauds fall into the second category. In the Criminal Law, there are
clear provisions on financial frauds aiming at illegal possession. However, there's no stipulation for
frauds under the second category, and hence only civil responsibilities could be investigated on such
Contract
behaviors in accordance with the Law. Moreover, some irregularities such as misuse of the
investors' settlement funds for stock trading and trust funds of the customers have long existed in the
financial sector, especially the securities sector and trust sector, which not only harm the legal
interests of the public but also generate huge risks to financial institutions. However, since the existing
Criminal Law
only contains provisions against misuse of customers' funds by the staff of the financial
institutions not that by the financial institutions, it fails to provide adequate deterrence for such a
malpractice. It is undoubted that the lack of criminal punishment for the above frauds and irregularities
will bring negative impact on reducing the operational risks in financial institutions.
Fourth, the lack of laws governing financial institutions and business will increase the potential risks in
the financial system. As mentioned above, the increase of cross-market risks has become one of the
new factors affecting the stability of China's financial system, which is mainly due to the
underdevelopment of laws to timely regulate the newly emerged financial institutions and business.
For example, under the existing legal framework, although the financial holding companies are
seemingly to be covered one way or another by certain provisions in laws such as the Law of the
People's Republic of China on the People' s Bank of Commercial Banking Law of the
China, the
People's Republic of China, the Law of the People's Republic of China on Banking Regulation and
Supervision, Securities Law of the People's Republic of China, Insurance Law of the
the and the
People's Republic of China, none of them fully solve the supervisory problems. In terms of the
financial business, to supervise various entrusted asset management business, the most active
crossmarket financial products, the CBRC, CSRC, CIRC each has its own supervisory standards to follow,
and there is no unified supervision in this regard. Since the existing laws fail to solve the problems
confronted in the supervision of financial holding companies and to provide strict legal definitions for
new financial business, potential risks are likely to increase and spread across different financial
markets. According to the definition made by the Basel Committee, the cross-market risks undertaken
by China's financial institutions are in essence legal risks.
III. Next step in optimizing the legal framework
As China's financial reform is accelerating, the task of preventing financial risks has become more
important and challenging. Given the innate risks associated with the financial sector, the legal
framework for the sector cannot eliminate all financial risks once and for all. However, a sound legal
framework may help deter imprudent risk-taking activities of financial institutions and reduce systemic
risks. Furthermore, a favorable legal environment is the precondition for the steady performance of the
financial system.
The PBC is stepping up its efforts in improving the legal framework for the financial sector. More
specifically, it is facilitating the formulation of the Regulations on Credit Information Management; it is
Enterprise Insolvency Law Criminal
actively involved in the amendment of the and the Law; it is
offering suggestions for the amendment of the Securities Law of the People's Republic of China; it is
Law on Anti-Money
drafting the Laundering; and it is doing research on the legal issues concerning
the market exit of financial institutions, deposit insurance, legislation for financial holding companies,
asset securitization, and entrusted wealth management. We hope to promulgate these laws,
regulations and implementary rules as soon as possible so as to effectively regulate certain important
financial activities. In a word, China's legal framework for the financial sector should be overhauled -
necessary new laws should be drafted, existing laws should be amended as appropriate, and outdated
laws should be invalidated.
In the long run, we should not only focus on legislation but also on the enforcement of existing laws. In
my view, the core issue of financial legislation lies in a scientific approach. Different stages of the
financial sector call for different approaches. At present, financial legislation should focus on improving
infrastructure of the financial market, regulating legal relationship concerning financial innovation,
advancing the coordination and effectiveness of financial supervision, and making the best use of
market self-discipline.
First, we shall approach financial legislation in a coordinated, scientific and comprehensive manner.
China's economic reform and financial reform are at a critical period, when the stand-alone strategy no
longer meets the requirement. Therefore, coordinated planning and rational thinking should prevail in
financial legislation. Specifically, we should gradually promote the integration and consolidation of the
financial market through legislation; regulate the trading of homogenous financial products through
identical supervisory rules; and ensure the consistency of the infrastructure (such as the rules on
issuance, registration, custody, settlement and liquidation) in different markets. We should apply
uniform rules in regulating the institutional innovation, business innovation and product innovation of
financial institutions. We should also work on the sharing and transmission of financial-risk-related
information among financial regulatory bodies. Other laws that support financial development and
reform should be amended so as to protect both the creditor and the debtor. The revision of the
Criminal Law
should also reflect the current social environment so as to highlight criminal sanctions on
corporate crime and the investigation of individual criminal liability.
Second, we should stick to the protection of the interest of the depositor, investor and creditor.
Protecting the interest of depositors of financial institutions and the interest of investors in financial
products is always an important factor in the maintenance of the reputation of financial institutions. Our
present task is to study the fundamental legal relationship in the financial sector and to standardize the
legal relationship concerning financial innovation products. While approving innovation products,
financial supervisory bodies should work hard to protect such lawful rights of the investors as the right
Insolvency
to know and the right to receive due return. We should step up our efforts in improving the
Law. Under the basic principles of the Insolvency Law, we should formulate, while taking into
Regulations on the
consideration the unique features of bankruptcy of financial institutions, the
Bankruptcy of Financial Institutions. We should also establish and improve the financial safety network
Regulations on Deposit
and formulate a series of supporting laws and regulations such as the
Insurance and the Rules on Administration of the Securities Investor Protection Fund.
Third, we should stress both self-discipline and external discipline. In drafting laws concerning financial
supervision, we should stress the importance of a sound and complete mechanism for corporate
governance by such players as commercial banks, brokers and listed companies. While emphasizing
the self-discipline of financial institutions, we should also guarantee the autonomy of these institutions
in their operation and leave sufficient room for their future development.
Fourth, we should raise the public awareness of financial risks and rules, which is one of the most
effective methods for preventing financial risks and ensuring financial safety. During the process, we
should foster the extensive publicity of credit culture, increase the awareness of risk prevention among
the public and investors, and preach the virtues of lawful investment.