Abstract
Having a devastating impact on the global economy, the 2008 financial crisis helped to point out the most critical issues in the international supervision of the banking sector. Thus, the recovery after the crisis began with a search for a new stable system that could establish stability in the financial markets. As an option for coping with the issues exposed and preventing similar downturns in the future, the Basel Committee on Banking Supervision developed a new framework aimed at supervising the global banking system.
Known as Basel III, the new plan is expected to have a positive influence on the financial and banking sectors of countries affected by the 2008 crisis. Moreover, the new framework has become the foundation of banking supervision in China. Because that country recently became involved in the new system, there are several critical challenges to address in order to make it operative. Therefore, the article at hand aims to describe these issues as well as speculate on ways to eliminate existing defects and improve the effectiveness of the banking supervision system in China.
The global economy is characterized by increased interdependence, which commonly results in high volatility risks due to the so-called spillover effect. One recent example of this trend is the 2008 financial crisis. This economic situation had a detrimental impact on global economic development because it exposed numerous problems that related to international banking supervision. For this reason, to overcome the identified issues and prevent potential future crises, a new and reliable system for supervising the banking and financial sectors was needed. The Basel Committee on Banking Supervision rose to the challenge in adopting the new framework for achieving global financial stability known as Basel III. The details were publicized in September 2010.
The introduction of the new framework has initiated numerous changes in different countries around the globe. For instance, in China, Basel III became the foundation for developing that country’s system for banking supervision. As it is a new phenomenon in the Chinese economic environment, the banking supervision system has varying defects. Therefore, it is essential to address these problems in order to offer recommendations for altering the system so that it corresponds with international standards of financial stability. Thus, the paper at hand aims to investigate the banking supervision system currently operating in China.
Stress will be laid on studying the specifics of macro-prudential supervision, financial market operation mechanisms, legal frameworks, and the activities of the Central Bank of China. In addition, the article will explore ways to eliminate the major challenges and alter the current system so that it complies with international standards of banking supervision and regulatory frameworks, particularly the provisions of Basel III.
The Novelty of Basel III in Terms of Banking Supervision
Basel III, a new framework for guaranteeing the soundness of the global banking system, aims at minimizing the risks of any future financial crises. The current framework was developed based on the strengths of the two previous versions of the framework—Basel I and Basel II. However, the specificity of the latest document puts the focus on connecting micro- and macro-prudential supervision of the banking sector (Giordana & Schumacher, 2013).
The foundation of the new program is assessment and monitoring of bank liquidity. Therefore, in order to correspond with the requirements of the new platform, banks should generate the necessary volume of additional capital. For this reason, the total implementation of the new system is expected at the end of 2018 (Ioana & Madalina, 2013). In this respect, it is possible to analyze the existing banking supervision systems and identify the gaps that should be filled by the set date.
As mentioned above, the new framework has been designed on the basis of the previous versions of the program. From this perspective, it is essential to point to the major novelties of Basel III compared to Basel I and Basel II. Most of the framework’s attention is paid to new capital requirements that would be beneficial for eliminating volatility risks and preventing future financial crises (Rudin, 2012). This focus is essential for assuring that banks have enough resources to cover losses in cases of emergency and economic turndowns. For this reason, capital should be kept on balance sheets (Rubio & Carrasco-Gallego, 2015).
In addition, in Basel III, special attention is paid to macro-prudential regulation, a topic that was not addressed in previous versions of the document. That said, the focus is fixed on the criticality of regulative institutions in avoiding liquidity risks and counter-circularity. Moreover, the influence of these institutions should be robust in the major banks of a particular country or the most important markets that are directly connected with the banking sector (Tressel & Verdier, 2014). Detailed Basel III requirements can be found in Table 1.
The defects of the Banking Supervision System in China Under the Framework of Basel III
China’s involvement in Basel-related activities is recent. In 2003, a special institution governed by the State Council was established. This body is referred to as the Chinese Banking Regulatory Commission, reflecting its connection to the Basel Committee. Due to the newness of the institution, there are some critical challenges to address. To begin with, it is essential to mention that the Chinese authorities have issued a China-specific version of the Basel III framework. It was promulgated in 2011 after the Basel Committee communicated the framework of Basel III. However, China’s approach of adopting standards higher than those of Basel III may potentially lead to a failure in meeting the requirements of both frameworks (Luo, 2016).
Macro- and Micro-Prudential Supervision
According to the new standards adopted in China, all banks are divided into two types: systemically important and other banks (Luo, 2016). This division corresponds with the provisions of Basel III, as the latter point to the criticality of monitoring the most important banks. However, the complexity of this issue in the Chinese environment is connected to a sophisticated system of macro- and micro-prudential regulation of the banking sector.
In China, the recently created Commission is not the only institution responsible for the regulation of the banking sector. Instead, the Central Bank, the Ministry of Finance, the National Audit Office, and the National Development and Reform Commission are also involved in regulatory activities (Huang & Schoenmaker, 2015). Due to identifying another tier in capital (three instead of the two determined by Basel III), the whole system is too sophisticated. This means that it is not properly arranged from an institutional perspective, and the efficiency of such a system of macro- and micro-prudential supervision is questionable. Because they focus on a different aspect of banks’ operation and measure it differently, any recommendations may be contradictory and may well ignore the most significant issues (Wang & Sun, 2013).
Lack of Complete Financial Market Exit Mechanism
Basel III focuses on guaranteeing financial stability. It is connected not only to effective regulatory measures but also to appropriate operational activities. From this perspective, it is essential to assure that there are adequate exit and restructuring mechanisms in case of emergency. In China, these mechanisms are poorly developed. This means that banks either cannot exit the financial market or are not restructured as needed. The result is increased volatility that becomes especially critical in the case of systemically important banks that have a direct influence on the whole banking sector and on the Chinese economy (Sheng & Soon, 2016).
Central Bank Overprotection
The inadequacy of the market-based exit mechanism is closely connected to the activities of the Central Bank of China. In most cases, its operations are not only regulative but also supportive—and sometimes overprotective. This can be explained as providing financial support to problematic banks. This support is usually granted in the form of loans and aid. In most cases, these loans are long-term so that paying them off leads to bankruptcy. This means that the activities of the Central Bank defer bankruptcy on the part of problematic banks that may have a potentially negative influence on the stability of the financial system and economy as the whole.
Moreover, these loans are granted in almost all cases of necessity. From this perspective, the Central Bank is referred to as the lender of last resort. The knowledge that the necessary financial aid is provided to all problematic banks is connected to risks of increased volatility because the management of these problematic banks is not motivated to cope with existing challenges and to put effort into saving the bank. This public perception of the Central Bank and its activities leads to explicit safety and impaired performance of the banks. In all, it jeopardizes the soundness of the whole system (International Monetary Fund, 2012).
Low Level of Legislation
All of the challenges and issues mentioned above are critical. However, it is essential to keep in mind that they derive from the imperfection of the currently adopted and operating legal frameworks. The central problem is the fact that the provisions of the legislation are ambiguous and do not establish a homogenous approach to conducting operations related to guaranteeing financial stability and soundness.
Even though banking provisions have been revised to correspond with international requirements and standards, there are still significant gaps in the legislation. For instance, most state agencies responsible for regulating the financial sector are protected by the state; that means that they are not responsible for the consequences of their recommendations and actions (International Monetary Fund, 2012). Furthermore, the current legislation promotes the existence of the sophisticated regulatory system described above and enhances consultations among all agencies involved in the process. This state of affairs makes the system less efficient and leads to the rest of the existing issues (Huang & Schoenmaker, 2015).
Suggestions for Improving the Banking Supervision System in China Under the Framework of Basel III
Based on the abovementioned findings, several recommendations may be advanced for improving supervision of the banking system in China. To begin with, it is advisable to establish an institutionally arranged system of macro- and micro-prudential supervision. The idea is to grant regulating functions to one institution, instead of sharing these activities among numerous state agencies (Wang & Sun, 2013). In addition, it is advisable to focus prudential supervision on the issues that are the most critical for establishing a stable and sound financial environment, including risk exposure, capital adequacy ratio, provisioning ratio, and non-performing assets rate (Huang & Schoenmaker, 2015). These steps would make the regulatory system homogenous and minimize the risks of contradictions.
Furthermore, it is critical to develop a financial market exit along with bank restructuring mechanisms in order to guarantee the stability of the financial sector. The recommendation is to establish an inter-agency that would be involved in this sector, address credit problems, and assure the soundness of the financial system (Sheng & Soon, 2016). In addition, it is advisable to focus on changing the policies of the Central Bank, paying special attention to making it less protective.
This step is directly associated with the need to establish adequate and complete market-based exit procedures for problematic banks instead of providing them with unnecessary support. From this perspective, the lender-of-last-resort option should be used cautiously (i.e., only in the case of potential recovery of a bank and its contribution to the improved condition of the financial and banking sectors). In addition, the Central Bank should control the regulative functions and guarantee that they correspond with the frameworks proposed by the Basel III provisions (Huang & Schoenmaker, 2015).
Nevertheless, it is critical to keep in mind that the recommendations mentioned above will be impossible to implement without making the legislative basis perfect and comprehensive. The idea is to overcome the currently existing challenge of poorly developed and ambiguous legislation and establish homogenous and universal frameworks for the operation of the financial and banking sectors (International Monetary Fund, 2012).
Conclusion
In summary, Basel III is a comprehensive policy framework. Due to incorporating detailed requirements and a focus on bank liquidity, the potential this framework offers for guaranteeing global financial stability is significant. However, it can be achieved only if authorities of all countries assure that their banking sectors operate according to the newest requirements. The latter provision is challenging because there are countries that are developing peculiar banking supervision systems, and China is one of these countries.
Due to the powerful influence China has on the development of the global economy, it is critical to guarantee that the Chinese banking and financial systems are sound and stable. However, this assurance is questionable under the new standards adopted by the Chinese Banking Regulatory Commission that differ from the Basel III requirements.
That said, it is essential to assure that the national standards comply with the Basel provisions, which is possible only in the case of an adequate operation of the central institutions connected to financial supervision and the appropriate legal frameworks. Therefore, in order to improve the banking supervision system in China under Basel III, it is advisable to reconfigure the functions of the regulatory institutions (including the support of the Central Bank), review legislation, and implement an efficient market-based exit mechanism for problematic banks (He, 2017).
References
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