In early March, at this year’s National People’s Congress, China’s leaders approved the State Council Institutional Reform Plan. It sets out to restructure government ministries and regulatory bodies to enhance policy and reform efficiency. For financial markets, the overhaul of the financial regulatory regime will be the main point of interest: Could it spell progress or regression in achieving a better outcome in the trade-off between stability and efficiency in capital allocation?
Some critics have already charged that the financial regulatory overhaul is another move by President Xi Jinping to centralise control by eroding the autonomy of China’s central bank. These extensive regulatory changes, critics argue, will lead to finance in China becoming more centralised and subject to greater political control.
The plan aims to streamline the supervisory functions of the People’s Bank of China’s (PBoC) and dismantle the China Banking and Insurance Regulatory Commission (CBIRC).
Taking over these institutions’ regulatory and supervisory functions will be a new ‘super-authority’ – the National Financial Regulatory Administration. Beijing will control the NFRA directly. All local PBoC branches will be closed and replaced by a local financial regulator involving a nationwide network of NFRA branches.
Critics believe this may subordinate the PBoC to the influence of central and local party chiefs. We see this as a valid concern given that the PBoC has been a pro-market regulator helping to advance financial liberalisation.
Policy efficacy could improve
From a policy management perspective, the changes mean the PBoC will focus on macro-prudential management and monetary policy. Micro-supervision of financial companies and consumer protection functions will be spun off to the NFRA. This should improve monetary policy specialisation and could arguably enhance macroeconomic policy efficacy.
Crucially, to be able to fully assess the plan in the context of China’s risk environment, one needs to understand the background to China’s structural problems. Centralising financial supervision in the NFRA – directly under Beijing’s control – could go a long way to addressing the incentive problem in the system that has seriously hampered financial reforms.
The collapse of China’s peer-to-peer (P2P) loans industry almost dragged China into a financial crisis in 2017-18. That event highlights the incentive problem, which is often aggravated by shortages and misallocations of regulatory resources.
The China Banking Regulatory Commission (CBRC, which was the predecessor of the CBIRC) and the local government where a P2P platform was registered, were supposed to regulate and supervise the P2P activities. But the regulators were seriously understaffed, making it impossible for them to properly oversee platforms that operated across different jurisdictions throughout the country.
Regulatory oversight became a hotbed for cheating and collusion. The local authorities formed symbiotic relationships with P2P platforms. The result was rent-seeking and corruption, with officials incentivised to turn a blind eye to financial irregularities.
This, in turn, allowed many P2P platforms to operate as illegal underground banks or even Ponzi schemes, pooling funds via the internet for lending and/or issuing wealth management products characterised by maturity mismatches, poor quality underlying assets, or implausible repayment guarantees.
Even though the CBRC outlawed these practices in August 2016, the eruption of the crisis in June 2018 clearly showed that no-one had complied with the ban.
With China’s regulatory reforms lagging, moral hazard, rent-seeking, and regulatory arbitrage (taking advantage of differing rules in different jurisdictions) have become rampant.
Arguably, under the plan, having the local financial system controlled by the NFRA should be a step towards correcting these problems. Centralising regulation and supervision should reduce the incentive problem among local regulators.
The ultimate question for China, and for investors, is whether there is a price to be paid for all these changes, even if the changes are the right ones.
From President Xi’s perspective, since the decentralisation of power in China has proven unworkable, there is a policy choice to be made. Should he take back power and force through reforms? Or should he stick with the prevailing system and await the day of reckoning?
 “Xi Closes a Door in China”, Lingling Wei, Wall Street Journal, printed edition, March 13, 2023.
 For detailed analysis of this problem, see “Chi Time: China’s P2P Crisis – Financial Innovation Backfires”, 27 August 2018 (here).
 The CBRC admitted in a private conversation in 2015 that it had only two to three full-time staff working on supervising, regulating and drafting rules for thousands of complex P2P platforms. See also “In China, P2P Insiders Say Regulatory Shortcomings Have Choked Industry”, Chen Leng and Engen Tham, Reuters, 6 September 2019 (here).
 The most famous case was the Ponzi scheme Ezubao involving USD 7.6 billion and over 900 000 investors (here).
 See reference in footnote 2.
 See “Chi on China: Mega Trends of China (6): Evolution of China’s Growth Model”, 6 April 2018 (here) and “Chi on China: Changing China’s Incentive Scheme in the New Growth Model”, 3 September 2018 (here).