A Study On The Macro-prudential Regulatory Framework In China

The global financial crisis since the twenty-first century and the recent sovereign debt crisis across the developed countries can all be somewhat attributed to regulatory failures. The essential reason lies in the micro-prudential regulatory philosophy taken by the pre-crisis countries that sound individual financial institutions make a sound financial system as a whole. In fact, operations of a financial institution often generate large negative externalities, especially when it’s over-connected with the outside world and involved in complex derivatives trading with excessive leverage. In response to the significant deficiencies in the financial regulation, a new regulatory concept comes into being, and is reflected in the Basel III and the reform of the regulatory pattern by the national regulatory authorities. Therefore, we can say that the macro-prudential regulation is a most fascinating topic in the financial sector. Although China’s financial system has not suffered direct losses in the global financial crisis, there are still systemic risk problems. The high house prices, shadow banking system and local government financing platform, for instance, are all risk factors in China’s financial system. Forward5-10years, a series of prospective reform in China, including its interest rate and exchange rate liberalization, transformation of its economic growth mode, new urbanization, financial openness, and mixed operations under financial holding company, is bound to challenge its financial stability. In that sense, a study on the macro-prudential regulatory framework in China, which is right the theme of this dissertation, has great practical significance.This dissertation starts with a review of domestic and foreign literature on the macro-prudential regulatory framework, mainly covering the measures of systemic risk, the shadow banking system, the macro-prudential tools practice and macro-prudential policy coordination. Thereafter, it describes the regulatory "philosophy evolution from Basel I to Basel III and thus introduces the concept of macro-prudential regulation. The macro-prudential regulatory framework consists of five elements:objectives, systemic risk measure, shadow banking system, macro-prudential instruments, institutional arrangements and policy coordination. The objective is the premise of the macro-prudential framework. Systemic risk measure and shadow banking system are the main body of the framework, of which the former is risk monitoring on the traditional financial system, while the latter is risk monitoring on the broader financial system. The last two elements are the purpose of the macro-prudential framework, designed to prevent and regulate systemic risk. This part also covers macro stress testing methods (addressing the time dimension of systemic risk) and CCA-based adjustment of balance sheet in three sectors (addressing the cross-sectional dimension).For one main body of the macro-prudential regulation framework, this dissertation devotes a large part to explore the measure of systemic risk in our financial system in three ways. Chapter four introduces the reduced form, which works as follows:a two-period microscopic model of banks and regulatory authorities is built to find out that the systemic expected loss of a financial institution is a measure of its contribution to systemic risk. In view of the low-frequency of the systemic crisis and the fact that monitoring has to be forward-looking, the marginal expected loss and the leverage ratio in the normal time are used to predict the systemic expected loss. The robustness of the prediction is empirically checked by varying the crisis definition, the indicators of marginal expected loss and the prediction sample. Chapter five introduces the integrated method, which works as follows:on the basis of the reduced form, DCC-GARCH and Monte Carlo simulation are used to measure the systemic expected loss of China’s financial institutions in single or more periods, and to estimate the systemic risk of China’s financial system in both dimensions. The estimate indicator in the time dimension is the probability of a systemic crisis in the financial system in60-period prediction. Due to its volatility and instability, this indicator is unsuitable for monitor indicators. The estimate indicator in the cross-sectional dimension is SRISK%:some of the large commercial banks in China face the highest level of systemic risk; most of the joint-stock commercial banks show strong systemic importance; the city commercial banks have the lowest level of systemic risk. The level of systemic importance, marginal expected loss and leverage are correlated to asset size, and leverage is the most important factor. Chapter six introduces structure method, which works as follows:in the time dimension, systemic default distance and average default distance are given with Merton option pricing formula; in the cross-sectional dimension, asset-weighted spillover risk indicators based on Directed Acyclic Graph(DAG) and based on the equation decomposition are given, with the default distance of the sample banks. It finds that the systemic risk of our banking system experienced a significant increase after September2007, peaked in October2008, and then decreased gradually, but still higher than before the crisis. Regarding the systemic importance of China’s banks, large state-owned commercial banks are the most important, followed by joint-stock commercial banks, and city commercial banks the least important. In the end, an all-round comparison is made among those three methods, in terms of classification, measure results, indicators and calculation complexity.For the other main body of the macro-prudential regulation framework, this dissertation first gives an analysis of the shadow banking system in the developed countries and then discusses the shadow banking system in China. It analyzes the credit intermediation and the regulation of shadow banking in the developed countries. The shadow banking credit intermediation consists of seven steps (Mortgage Origination, Mortgage Warehousing, ABS Issuance, ABS Warehousing, ABS CDO Issuance, ABS Intermediation and Wholesale Funding). By these seven steps, it realizes credit, term, and liquidity transformation and essentially tranfers risky assets into high-liquid liabilities that are risk-insensitive. In this part, based on the monetary liabilities (mainly due to liquidity and credit guarantees in the private sector, as well as information asymmetry and information friction) issued by the shadow banking, a Risk Decision Model containing efficiency financial institutions, traditional banks and shadow banks is built to explain the reasons for the need to regulate the shadow banking. For one thing, the shadow banks issue risk-insensitive liabilities, and thus take more asset risk, leverage risk and liquidity risk than the efficiency financial institutions which issue risk-sensitive liabilities. For another thing, different from the regular banking which receives capital regulation, the shadow banking is unregulated. As a result, in normal times, the shadow banks take higher asset risk, leverage risk and liquidity risk than the regular banks. Therefore, we need to strengthen supervision on the shadow banking. The steps to monitor shadow banking system include: Scanning and mapping of the overall shadow banking system; Identification of the aspects of the shadow banking system posing systemic risk or regulatory arbitrage concerns; Detailed assessment of systemip risk and/or regulatory arbitrage concerns. Supervision of systemic risk in the shadow banking system should target at five areas: the spill-over effect between the regular banking system and the shadow banking system, money market funds (MMFs), other shadow banking entities, securitization, secured financing contracts such as repos and securities lending. The shadow banking system in developed countries are quite different from that in China, for instance, in structure, financing model, operating mechanism, scale, investment targets and leverage. The bank’s off-balance sheet wealth management business is the most important part of China’s shadow banking system, and there are three main reasons for its rapid growth in recent years. First, from the capital pool, there is a rapid increase in demand for financial products by investors, due to the increase in wealth and in income gap and the limited investment channels. From the asset pool, the demand for funds by the real economy, especially small and medium-sized enterprises, has gone far beyond the limited bank loans. From the bank side, the regulatory arbitrage motivates the rapid growth of financial products. Overall, the rapid growth in financial products is an external expression of the interest rate liberalization in China. Bank financial products business poses risks, such as liquidity risk caused by maturity mismatch, channel risk of shadow banking intermediaries, the credit risk of the asset pool, operational risk due to lack of custodian for its financial products, as well as reputation risk and market risk due to implicit guarantee on its financial products. On the whole, China’s shadow banking should be regulated in a targeted way, and it should not be blocked but guided.For the objective of the macro-prudential regulation framework, this research focuses on the macro-prudential instruments and their coordination. IMF survey data is used to analyze the category, application and effectiveness of the instrumnets. Based on this analysis, practice on the macro-prudential regulation in China is discussed. The most commonly used macro-prudential instruments can be categorized as credit-related instruments, liquidity-related instruments and capital-related instruments. These tools are usually used in combination, not targeted at specific objectives, and based on the discretion. In general, macro-prudential tools are more frequently employed in the countries which have a low level of economic development, a small-sized financial sector, and a fixed exchange rate regime and which are subject to large capital flows. The research also finds that most of the macro-prudential tools are effective. On the basis of those results, this part also explores some macro-prudential tools that may be effective in response to China’s real ’estate price risk.Finally, discussion on the coordination mechanism of macro-prudential insruments starts with the transmission of macro-prudential policy and the interaction between macro-prudential policy and monetary policy. Different from monetary policy, the transmission of macro-prudential policy is related to the tools used and the financial cycle. The tightening macro-prudential policies can all be effectively transmissed, expectation of market participants playing a very important role. The transmission of loose macro-prudential policy differs in crisis time and non-crisis time. In non-crisis time, loose macro-prudential policy is effective and its transmission is opposite to tightening macro-prudential policy. In times of crisis, loose macro-prudential policy depends on the existence of the "ratcheting-up effect". It is effective when the "ratcheting-up effect" exists; otherwise, it is similar to the monetary policy during the recession, and not much effective. The expectation factor gives loose monetary policy certain validity. The macro-prudential policy and monetary policy interact with each other:the macro-prudential policy is conducive to the transmission of monetary policy in times of crisis, protecting its policy rate against lower-bound constraint; meanwhile, monetary policy affects financial stability through its effect on the borrower’s mortgage limit, banks’ risk-taking channel, and the negative externalities of asset prices and exchange rate. This research explores the bank’s risk-taking channel, using data on China’s banking, and discusses the coordination between monetary policy and macro-prudential policy.