Zhou Xiaochuan: Improve legal system and financial ecology
Speech by Mr Zhou Xiaochuan, Governor of the People's Bank of China, at the "Forum of 50 Chinese
Economists", Beijing, 2 December 2004.
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Distinguished guests, ladies and gentlemen,
I am very glad to have this opportunity to attend the conference organized by the Forum of 50 Chinese
Economists and wish to stimulate, through the anticipated discussions, academic research and to
contribute to policy-making and reforms. In the process of financial reform, we have spent a huge
amount of resources in addressing non-performing loans (NPLs), resolving potential financial risks and
avoiding financial crisis. In the next round of financial reforms, there are important areas in which that
we must take actions, such as financial legislation, especially the insolvency law and laws concerning
loan frauds, and certainly accounting rules and standards. Legal issues have a direct bearing on the
financial ecology of our economy. At present, some related issues have become acute and important. I
would like to take this opportunity to share my views with you and hopefully provide some initial
thoughts for further study.
I. With the deepening of economic transition, financial risks have taken variable forms
and the potential risks that need to be addressed continue to change
There are many underlying reasons for financial risks. First, the rapid global economic, technological
and financial development has made it difficult to address new problems with existing theories and
experiences. Among these are the uncertainties in financial stability. Second, in the transition from
planned to market economy, some aspects of institution building is still in a vague, non-planned and
non-market, or conflicting stage. Third, reality has proved that all kinds of problems in the economy are
reflected in the workings of the financial system, which was particularly evident during the Asian
financial crisis. Financial risks, if not addressed in a timely manner, could continue to grow and
develop into economic and financial crisis. We must put more emphasis on understanding the financial
risks and the uncertainties involved. Only by taking timely measures, could potential risks be removed.
It is a world-wide experience that the longer the risks are left unattended, the harder it is to solve them.
When the economy is in transition, financial risks at different stages takes different forms with their
nature and characteristics constantly changing. Some of the important problems we faced yesterday
are no longer important today, and some of the minor issues of yesterday have developed into
significant ones today. For instance, in the recent past, the most important problem we faced was the
disposal of large NPLs. In 1998, 270 billion yuan of special treasury bonds were issued to re-capitalize
the state commercial banks. In 1999, asset management companies were set up to take over
1000 billion yuan of NPLs. At the end of 2003, Bank of China and China Construction Bank introduced
share-holding reform on a trial basis. The two banks wrote off non-performing assets with existing
capital, which was followed by state capital injection with foreign exchange and gold reserves. The
reform of rural credit unions was stepped up with financial support from the government.
In order to tackle the NPL problem at its root, we conducted a detailed survey and obtained a general
picture of the historical causes of NPLs. This work provided a basis for addressing the NPLs and
designing the blueprint of state commercial bank reform. According to this survey, 30 percent of the
NPLs resulted from state planning and administrative intervention, 30 percent was due to defaults of
state enterprises after state banks providing financing based on state policy, 10 percent came from
structural adjustments as a result of state orchestrated closure, merge and transformation of
enterprises, 10 percent stemmed from intervention of local governments including poor creditor
protection in the judicial and enforcement process, while 20 percent was due to the inappropriate
internal management. In addition, factors, such as poor credit culture, intentional defaults and
inadequate application of accounting standard, can be found in all above categories. One striking truth
is that many of these causes related to legal, judicial and enforcement practices.
As old problems are gone with reforms, new ones begin to emerge. For instance, some of the past
causes of NPLs, such as policy lending, inappropriate administrative intervention, unbalanced
centrallocal relations and poor internal control within commercial banks have begun to dissolve. At the
beginning of reforms, the thinking of administrative separation of powers between the central and local
governments had an adverse impact on the effectiveness of internal controls within commercial banks.
In such a setup, loan organization was decentralized to provincial, regional, city and even county level
and a "three-eye practice" being followed with each eye looking separately at the head-office of the
bank, the local government and the supervisor, the local branch of the People's Bank of China (PBC).
At the early stage of reform, telecommunication was not as developed as today so the daily operation
and supervision were, to a great extent, subject to the control of local interests. This led to weak
internal controls within banks. When I was working at a commercial bank in the early 1990s, I found
that there were many detailed rules and regulations. From appearance, the institutional building was
sound, but people at the head-office knew that implementation was usually another story. Therefore,
making rules and regulations was to a great extent a means of shirking responsibility. The branches
were operating with three eyes and any mistakes resulted would not be the responsibility of the
headoffice.
It was not until the convening of the 3rd Plenary Session of the 14th National Congress of the CPC in
1993 that emphasis was placed on strengthening internal controls within banks. At the time, it was
stressed that specialized banks needed to be transformed into comprehensive, enterprise-like,
commercial banks without direct administrative controls. However, changes always take time. It was
not until 1997 when lessons from Asian financial crisis were learned and when the Central Financial
Work Conference was held that the commercial banks started to introduce vertical management of
business and staff, creating needed conditions for strengthening internal controls.
Other causes of NPLs, such as those associated with inadequate supervisory system and the state
owned enterprises, have been changing and gradually diminishing. For instance, one problem with the
supervisory system at the early stage was, put it simply, "tighten licensing and loose supervision",
i.e. once a license was issued, no supervisory follow-up. After the Asian financial crisis, the Chinese
government basically stopped administrative intervention in state-owned commercial banks as laws
defining banks' lending autonomy were put into place. Starting from the beginning of this century, the
government has gradually refrained from asking the state-owned banks to follow policies that favor
state owned enterprises. As the SOEs reform deepened, some big SOEs became public listed
companies and the improvements in business operation also allowed commercial banks to improve
asset quality. In general, the old NPL problem is being resolved. As the economy enters a new stage
of development, there are going to be many new problems that would require our attention.
It is for the above reasons, the Research Department of the PBC finished a report on the potential
financial risks facing China. According to the report, financial risks may arise from nine aspects: the
high saving rate and the rapid rise of M2 lead to high concentration of financial risks in the banking
sector; the stability of the value of RMB is still under great potential pressures; the experiences around
the globe prove that financial instability may arise from fiscal deficits; rigid exchange rate system and
imbalances of payments contain significant risks; bank clients and bank-enterprise relationship also
hold significant risk; some existing governance problems may require further state financial rescue if
not addressed timely; the lack of autonomy and scientific techniques in pricing loans may give rise to
significant financial risk; the inadequate innovation mechanism may lead to rigidity that constrain
competition; and, a balance needs to be struck between maintaining financial stability and preventing
moral hazards.
Many of the above relate to the legal problems in our financial ecological environment. For instance,
looking at the bank-enterprise relationship, the Chinese enterprises have high financial leverages with
low self-owned capital and relying mainly on bank lending. Can banks completely rely on external
information or have to resort to internal information to some degree? When default happens, would the
legal arrangements be helpful to protect creditor rights and minimize the losses? Risks in the economy
make the forming of NPLs unavoidable, yet in the process of disposing of NPLs, how much control do
banks have as the creditors? As for the bank-enterprise relationship should it be control-oriented or be
at-arms-length? Answers to the above relate closely to legal conditions or "established practices" and
concern accounting standard, external auditing, disclosure, law enforcement, and accessibility of
market information. In bank-enterprise relationship, in addition to normal checks and balances, the
more important thing is whether the banks have a deterrence of last resort against the borrowing
enterprises. As a creditor, the bank would wish the borrowing enterprise to fix its problems as soon as
possible. Even so, it is inevitable that some enterprises go default. In the later case, it is a key issue
whether the legal arrangements and claims can be ensured effectively and efficiently in line with the
insolvency law.
Maintaining financial stability and preventing moral hazards are also closely related to the legal
environment. Without an explicit legal framework for closing and liquidating financial institutions, we
may take measures without legal basis and cannot guarantee being "fair and square" in addressing
financial stability issues. This may have social stability consequences as the laws do not define clearly
the rights and responsibilities of the investors and depositors and that the market participants have no
expectation of risks and could not make informed decisions. Whether the market participants can and
how they should discipline financial markets and financial institutions also demand clarifications on the
base of law.
II. Issues currently under debate
Today, I would like to raise a number of topical issues again, namely, insolvency law, loan frauds, and
accounting standards that relate to loan frauds.
1. Insolvency law
It has been long since financial reform and enterprises waited for an up-to-date insolvency law. The
provisional Enterprises Insolvency Law was enacted in the early stage of economic transition. As the
market economy evolves, the law has become out dated in terms of coverage, liquidation and
restructuring arrangement. Despite subsequent amendments and legal interpretations of the law when
it was applied in the GITIC case, the law in its present form cannot provide the standard financial
discipline and constraints required by socialist market economy. I learnt about some of the arguments
over the new draft of the law. My concerns lie in four aspects.
First, the process of liquidation, which involves giving priority to secured claims. Some are in favor of
employees' entitlements being paid ahead of the secured claims. Unpaid entitlements usually are
understood to be unpaid salary, yet in a broader interpretation they could also cover unpaid basic
social security, pension, healthcare and displacement or reemployment of workers. Without a clear-cut
definition of unpaid employees' entitlements, the ambiguity may result in a low recovery rate of
secured claims. In addition, issues concerning pension, healthcare insurance, re-employment are still
in the stage of debate and are not clearly defined themselves.
Second, the test for entry into formal insolvency process. According to legal theories, generally an
enterprise can be sued for bankruptcy if failing to honor its due debts, which implies that the creditor
can use bankruptcy suits as a deterrence to force an enterprise to repay debt. If this cannot succeed,
court procedure could begin, in which case, an administrator will be appointed, creditors committee
established, and all rights of control and management over the enterprise be taken over by the
creditors. The process is crucial for protecting the interests of a creditor. In reality, many of the
lawsuits brought up against debtors do not intend to force enterprises into bankruptcy but rather to
either increase the pressure for the enterprises to honor their debts or provide an opportunity for
enterprises to restructure. In the restructuring process, the creditors can revive the insolvent
enterprises through debt relief, extension and rollover in contrast to dismantling them and collecting a
heap of useless wreckages. However, if using "balance sheet test", the effectiveness of bankruptcy
litigation will be compromised, leaving a seemingly good-looking shape without any meaningful
substance. Especially, balance sheet insolvency involves accounting issue and thus is subject to
distortion and manipulation, to which I will come back later. This relates to whether the insolvency law
plays a role of hard constraint or soft constraint and this concerns whether the transition can go out of
what Cornell called "soft financial constraint".
Third, whether insolvency law is a specialized law that requires the establishment of a specialized
court. In appearance, there is nothing complicated about insolvency law. If an enterprise fails to honor
its due debt, it will be sued for bankruptcy. However, a court may need very specialized knowledge to
render the case when it involves complicated claim structure, conflicting tax requirements, employees'
claim, and especially restructuring. For instance, different claims, such as collaterals, superior debts,
subordinate debts, have different repayment priority; while, restructuring, similar to merger and
acquisition, is a very complicated process. There are always doubts about whether local courts can do
a good job in dealing with insolvency cases.
Fourth, whether financial institutions should be covered under a general insolvency law. According to
international practice and recommendations of IFIs, financial institutions should be subject to a general
insolvency law. Another view is that as bankruptcy of financial institutions would involve depositors
and creditors, without a deposit insurance system and investor compensation fund, the liquidation of
financial institutions would be much more complicated. For this reason some people are in favor of
"special treatment by the State Council" when it comes to financial institutions. Whether this will result
in a prolonged process of enacting a financial institution insolvency law? Then there will be endless
debates and may prevent a deposit insurance system and investors compensation system being put
into place in the near future.
2. Loan frauds
Based on what have happened in the country, financial frauds can be classified into two categories.
One is that through providing false information to reach the goal of illegal possession of financial
assets. What is typical of such frauds is that the criminal has the intention of gaining ownership of
financial assets through illegal means such as making false use of funds or providing false certificates
for ownership of funds. Letter of credit frauds and frauds with financial bills are all examples of such
schemes which are regarded as illegal by the Chinese laws. Second, the agent does not have the
intention of illegal possession of funds, but it is carried out through intentionally providing false
financial information in order to obtain loans from banks for the benefit of the enterprise. In such
frauds, the agent's statement of the purpose of the loans is true, i.e. the agent does not have the
purpose of taking the money for himself, but it intentionally provides the banks with false financial
information of the enterprise to misguide banks in decision-making. At present most of the financial
frauds are of the second kind.
At present, Article 193 of the Criminal Law of China has explicit stipulations against frauds with
intended illegal possession of funds. However, as for the second kind of frauds, they are not regarded
as financial frauds by law since the purpose of providing false information is not illegal possession of
funds but rather to obtain bank loans. Criminal charges will only be filed when illegal possession of
loans has happened. Otherwise, only civil charges can be brought up against the agent under
Contract
Law. The lack of legal deterrence will have significant impact on setting up strict financial
disciplines and whether banks will accumulate large amounts of NPLs.
According the international comparison done by KPMG, frauds stemmed from false financial
information has come to the center of attention in many countries. Germany, U.S. and U.K. have made
it very clear that financial frauds using falsified financial information is subject to punishment under
criminal law rather than civil law. For example, in German Criminal Code, Article 265 b stipulates that
using untrue or incomplete documents, submitting untrue or incomplete written statement or giving no
references about the true financial situation that is of significance for lending decisions of a bank are
financial frauds. The US criminal law also contains similar stipulations with emphasis on the agent's
intent rather than whether a purpose was fulfilled. And the credit or loans include all kinds of loans,
loan commitments and guarantees and cover not only the application stage but also the credit renewal
and rollover stage. The truthfulness requirements of the British law are similar to those in German and
US laws, and treat reckless forecast as one of the conditions for criminal charges.
3. Accounting standards
Frauds using falsified financial information have direct connection with accounting standards. False
information is either made-up information with no support from actual projects or relates to accounting
standards and codes. Since the beginning of reform, China has made progress in improving
accounting codes. Apparently, the designing and implementation of accounting codes can influence
information truthfulness and give rise to the opportunities to produce false information.
Accounting codes is a very technical issue. Many think the accounting codes as a "steel ruler" that
allows no vagueness. However, the complexity of modern economy has put some areas of accounting
subject to discretion and interpretation or even personal preference which result in a ruler with
flexibility. The issue of accounting codes did not attract much attention at the beginning of the reform.
It was not until 1993 that reforms were witnessed in corporate accounting and regulations. During the
Asian financial crisis we made more concrete progress in improving the account rules, which we
should recognize and value. At the same time, we should also be mindful that more should be done to
bring our accounting rules up to the international standards. Some people still think in China we have
too complicated an accounting system including a corporate accounting system and also distinctive
accounting systems for different industries. For instance, some corporate accounting rules require
enterprises to build value-loss reserves based on the recoverability of assets. Although accounting
rules of different industries have similar requirements, they are all inadequate in terms of soundness
comparing to corporate accounting rules. Another issue is that, since we did not have the luxury of a
strong accounting industry and external auditing facilities, when banks assessed the reliability of
enterprises' financial information, they did not require borrowers to provide external auditing results. In
the future, banks may consider require financial information audited by accounting firms and
assessment on enterprises' compliance and borrowing conditions made by law firms, and valuation of
collaterals made by evaluation firms and bond classes given by rating firms. However, it may take
years for the above intermediate services to develop, and the expertise, reputation, brand-name,
service quality also take tens of years to build. Are the audited statements trustworthy? It really
depends and relates to the expertise and internal control of the firms. The development of intermediate
financial service providers is affected by market liberalization as well. If all of these issues cannot be
dealt with effectively, probability of enterprises' providing false information and engaging in financial
frauds will continue to be high.
I would very much like to hear the comments on what I have said from experts and researchers
present today. Your opinions will be instrumental to our work.
III. Impact of legal environment on financial ecology
Legal environment has a direct impact on financial ecology. To some extent, in the transition from a
planned economy to a market economy, one fundamental issue is "soft financial constraint". Whether it
will continue to exist depends to a large extent on the transition and improvement of law and
enforcement. There are many interesting cases. Here I would talk about a few and stay away from the
theories.
The first one is of the recovery rate of AMCs. When they were established in 1999 to take over the
NPLs from state commercial banks, we invited renowned and very experienced experts and officials
from the World Bank and Eastern European countries to make an estimation of the recovery rate. In
private they thought it could reach 40 percent to 45 percent with a precondition that improvements
being made in legislation, judiciary system and enforcement to buttress the recovery and restructuring
work. Seeing that the enterprises were running and selling products as usual even with low capital and
heavy historical and social burdens, they thought these enterprises could survive as long as their
burdens could be removed. However, judging from the actual outcome, the NPL recovery rate was
lower than 20 percent. Even though NPL disposal has not come to an end, as time goes by, only the
assets of worse quality left and the recovery rate would be even lower. The overall recovery rate
depends on many factors, such as the process of diversification of ownership, but most importantly, it
hinges on the legal system of the financial ecology: is there an applicable insolvency law? Are there
specific laws regarding asset disposal? In 1989 the Financial Institutions Reform, Recovery and
Re-enforcement Act of the US laid a specific legal framework for restructuring RTC. In Poland, banks
are given semi-judicial powers in negotiations with debtors in enterprise restructuring and
bankdominant "out-of-court settlement" has strong legal power. In addition, Sweden, Romania, Bulgaria
and other countries have made protective arrangements, giving priority to creditors in asset
restructuring and recovering. Whether a specialized court should be set up? Whether foreclosure of
collaterals can be removed in order to uphold ownership of collateral in a simple and expedient way?
These questions are the preconditions for setting up AMCs and raise recovery rate. For this reason, a
book entitled Reconstruction and Rejuvenation-International Experiences in Resolving Non-performing
Loans was published when 4 AMCs were set up in 1999. While pointing out the importance of
improving banks internal controls, the book emphasized the importance of improving the legal system,
including Guarantee Law, Negotiable Bills Law and Securities Law, and strengthening law
enforcement and especially clarifying creditors' and debtors' rights and responsibilities. Furthermore,
the book calls for revamping of the bankruptcy law as in reality, a large proportion of NPLs derived
from abusing the bankruptcy procedure with a certain amount of false bankruptcies and those either
due to loopholes in the legal system or administrative impediments. Certainly, the low recovery rate
can be partially attributed to internal incentives, bureaucratic working style and ineffective work with
the AMCs. But the impact of inadequate legal system on low recovery rate as well as on national
economy should not be underestimated. This is not only because 1 trillion yuan worth of NPLs were
transferred to the AMCs but also that Bank of China and the China Construction Bank transferred
another 300 billion yuan NPLs at market price to Sinda AMC. Similar things will happen in the reform
of the Industrial and Commercial Bank of China and the Agricultural Bank of China. The difference of a
good legal, judicial and enforcement system and that of a bad one can be in the scale as much as
several hundred billion to a trillion yuan of cost to the country.
The second example is about a bank that sold its NPLs in a package to the local government. So far
the recovery rate is an encouragingly 30 percent, higher than expected. This could be contributed to
the active role played by the local government, which has wielded its power in re-enforcing judicial,
enforcement and restructuring processes and making arrangement to deal with employee entitlements
such as retirement, laid-off, and health care benefit. Despite the better outcome than what a bank
alone could have achieved, this practice itself is not without controversy. Because it raises two
questions: first, whether the bank as the creditor is in a disadvantaged position in that it has no
controlling power over the borrowing enterprise; second, whether the administration is more powerful
than the market. There is a saying about law suits concerning defaults, which is that even if a creditor
sues, the court may not take the case; even if it takes the case, it may not hear the case; even if it
hears the case, it may not adjudge; even if it adjudges, the ruling may not be enforced. Banks often
complain they lose money even when they win default lawsuits. In bankruptcy cases, this is common
too, and of course banks don't always win. As a result, commercial banks and AMCs seldom resort to
bankruptcy procedures against debtors, because it may result in a series of unknown events, such as
whether it may bring even bigger moral hazard risks? An enterprise may think if it defaults on a loan,
the debt servicing responsibility may be transferred to the local government that may help to
restructure the loan. This may lead to moral hazards in financial discipline. According to the general
rule of market economy, the defaulter may face risks of going bankrupt, and the debt cannot be
restructured without consent of the creditor. Second, the reform is heading for lesser government
involvement in enterprise management. If the practice in the above case was to be promoted as a
successful experience, it might lead to deeper involvement of the administration in enterprise
management. Would this be a desirable outcome? In addition, the reason why local government was
invited in disposing of the NPLs may be that it can influence the judicial and enforcement institutions.
But is this indeed a good thing?
The third example concerns the need for judicial specialization. In some cases, when a rumor surfaces
that an enterprise is in trouble, local court officials will quickly go to the local offices of securities firms
or commercial banks in other cities or provinces asking that the enterprise's accounts and assets be
frozen. If the staff of these institutions does not cooperate, they are accused of obstructing law
enforcement. For example, recently officials from one local high court came to the People's Bank of
China and asked that the accounts of a local government of another province be frozen. Many similar
cases continue to arise and underline the need for the establishment of a specialized court to
adjudicate complex financial issues.
A fourth example is of bankruptcy dictated by government policy. In such cases, the state-owned
enterprises must first pay their historical debts and entitlements to employees. According to
government policy, an enterprise may sell its land rights to raise money to make payment even if the
land rights have been used as collateral for other loans. If this is not enough, the enterprise can begin
disposing of its assets to satisfy its obligations. In this case, the enterprise must first dispose of assets
not used as collateral. After these assets have been sold, the enterprise then may sell assets used to
secure loans. Accordingly, in these cases banks recoup on average less than 1.2 percent of their
loans, many times lower then they expected. If priority is given to employee entitlements over secured
debt, and such payment order and conditions be generalized and promoted to apply to all enterprises,
banks might be forced to take defensive measures and create unfavorable financial conditions for
enterprises.
IV. Microeconomic analysis of financial ecology
The soundness of legal system can visibly change expectations of economic entities at the micro level.
From the point of view of borrowers, as long as there are legal loopholes, the borrowers can use
intermediate institutions, or through setting up relationship with bank officials or take advantage of
incomplete information or using falsified information to obtain bank loans. Without the act of illegal
possession of funds, it is hard for banks to bring charges against the borrowers. Even when banks
want bring forward bankruptcy law suits, the borrowers can use accounting rules to manipulate
statements to show that they do not meet criteria of insolvency to avoid going to court. Even when
banks successfully sued, before the court decision, enterprises could postpone paying wage,
healthcare and pension or create some entitlement items in order to deplete the liquidation funds and
leave nothing to creditors. Anyone who is smart may want take advantage of opportunities given by
law. And this obviously has significant adverse impact on establishing financial constraints of a market
economy.
General Rules on Loans
The perceptions of commercial banks may change too. requires to
differentiate credit and guarantees (including secured loans). The Rules require secured loans
including collateral for payment commitment and LC. Secured loans are often guaranteed. However, if
their priority in liquidation is being lowered, it may create chaos in bank managers' perception as to
whether all loans are treated as credit loans? In a microeconomic sense this may create confusion in
banks' lending practice. In this vein the banking sector earnestly looks forward to an insolvency law
that is in line with international practice.
In terms of liquidation order, giving priority to employees' entitlement definitely makes social and
political sense. However, it should be noted that social security issues should be dealt with by the
social security system through setting up good pension system, healthcare system, social security
system and unemployment insurance system to protect employees' interests. While the insolvency law
should define insolvency procedures with emphasis on fair liquidation rights and protecting creditors'
right. Different issues should be dealt with different rules. Any mismatch of issues and solutions, which
is like giving John the medicine to treat the sickness of Joe, would result in the continued existence of
soft budget constraint that has been there from the beginning of reform. With problems not being
addressed at their roots, larger amount of NPLs may continue to emerge.
V. Macroeconomic analysis of financial ecology
First, if the NPLs remain at a high level and continue to accumulate, a financial crsis may be in the
making. Based on lessons learnt from the Asian financial crisis, at the appearance, the crisis started
from Thailand and was induced by exchange rate and foreign debt pressures. While in fact, factors
such as corporate governance, asset and liability mismatch and out-of-date insolvency law also
contributed to the crisis. At present, our financial i