A politicized financial system may become more unstable as centralized control grows.
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The demise of Silicon Valley Bank, Credit Suisse, and other lesser banks in the US and Europe brutally demonstrated the costs of regulation failure and financial volatility. Lessons from these events should not only be applied locally. We would be wise to keep in mind that China’s internationally significant financial system shares some of our weaknesses while also having many vulnerabilities of its own creation. A new regulation reorganization may make such dangers more severe.
Over the past few years, China has dealt with the collapse of a number of smaller, regional banks, which in particular led to demonstrations by customers at banks in the province of Henan. The People’s Bank of China, in its quarterly assessment, stated that approximately 316 of these institutions were high risk at the end of 2021, despite the fact that these breakdowns appear to have subsided for the time being.
Early in March, China revealed significant regulation changes at the National People’s Congress that will greatly increase financial centralization and political control.
The banking sector’s state agencies will change. The control of banking and insurance will be transferred to a new national financial regulating body. Additionally, it is gaining from the People’s Bank of China and the China Securities Regulatory Commission some supervision obligations in customer and investment security as well as some regulatory duties for financial holding companies. The latter will continue to exist as a distinct organization and supervise the issuing of bonds by China’s fiscally troubled local administrations.
The Communist party’s position will be expanded to give it more power as part of a larger strategy, which also includes reforms to state agencies. To regulate party-related activities in the financial system, a Central Financial Commission and a Central Financial Work Committee will be created. The objective is to guarantee that complete political control, regulation authority, and supervision are applied to all economic areas. The drastic changes reflect the government’s anxiety over financial volatility and are evocative of the so-called “rectification” campaign launched against technology and data platforms from 2020 to the present.
If China wishes to achieve a better equilibrium in the trade-off between security and effectiveness in capital distribution, the important issue at this point is whether increased centralization and politicization of financial regulation is suitable.
China’s decision to centralize power is a significant wager on security. It might reduce system division and stop financial middlemen’ propensity to participate in frequently unstable trading between the regulation and province agency compartments. From the perspective of the Communist party, it might also assist in improving the efficiency of capital distribution and bringing some sort of order to the local governments’ chaotic financial situation.
Centralization and governmental authority, however, may also act as triggers for financial volatility rather than as protective factors. Financial volatility is always more probable when the balance accounts of financial organizations are closely linked, whether in a capitalism or party-state structure like China. Since the government reduced underground banking, China’s 4,000 or so banks already fall under state supervision and make up the majority of the financial system.
Coordinated balance sheet fluctuations are uncommon in decentralized organizations. Smaller, moving disturbances are much easier to manage and present much lower overall risk. Regulators can be more discriminating in their actions to turn over poor debt and eliminate or reduce implied assurances. This could lessen the danger of a more widespread moral hazard in a society where taking risks is supported by the government.
Greater centralization in China might actually be detrimental to the government as it increases the risk of financial volatility as market players all follow the same behavioral model. More consistency in the balance sheet behavior of the system would then exacerbate fault lines like bad debt, illiquidity, and other issues, including poor decision-making. Bubbles are apt to form, for example, if all institutions give to the same industry.
Charles Calomiris and Stephen Haber emphasized that nations obtain the banking system that their political structures will permit in their 2014 book on the financial crisis Fragile By Design. As China’s politicized financial sector advances toward greater centralization and represents the party’s decisions under president Xi Jinping, we would all do well to keep this in mind.