China’s Frankenstein banking system keeps growing
Financial regulation in China is quite a mess. China seems to be the world testing ground for some of the most ridiculous banking rules. With all their related unexpected consequences.
Take this recent story: some time ago, Chinese regulators found it clever to cap Chinese banks’ loans/deposits ratios at 75% by the end of each quarter (it isn’t). The goal was to ensure that banks have enough liquidity to face large cash withdrawals. Nevermind that loans/deposits only take into account loans from the asset side of the balance sheet and that banks can use depositors cash to invest in many different sorts of assets (from liquid sovereign bonds and short-term repos to very illiquid securities). Perhaps Chinese banking rules forbid some of those investments (I am not an expert on the Chinese banking system). The fact that the rule was only enforced at quarter-end seemed not to be a problem either (arbitrage anyone?), or that the news that a bank hadn’t complied with the rule could trigger a panic.
Nevertheless, as usual with China, the spontaneous financial order reacts. As the FT reports:
In recent years, the final few days of each quarter have become a nervous time for banks. As liquidity has tightened and many depositors have shifted their savings into higher-yielding substitutes such as Alibaba’s online money-market fund, Yu’E Bao, many lenders have struggled to attract enough traditional deposits to stay below the maximum 75 per cent loan-to-deposit ratio.
That regulation, intended to ensure banks keep enough cash on hand to meet withdrawal demand, is enforced at the end of each quarter – providing an incentive to window-dress deposit totals. This was exacerbated by the desire to prettify quarterly reports to shareholders.
To meet the deposit challenge, many banks resorted to an all-hands-on-deck approach, requiring employees to meet a deposit target. That meant urging clients – and even family and friends – to transfer funds into the bank, typically only for a few days covering the quarter-end period.
Typical example of a rule that, not only introduces opacity, but also creates unintended consequences.
But the story isn’t over.
Chinese regulators didn’t really appreciate that bankers were trying to bypass their well-thought-out rule. They came up with another very ‘clever’ rule to fix the flawed rule:
Regulators will suspend business approvals to banks whose month-end deposit total deviates by more than 3 per cent from the daily average over the previous month.
Problem solved. Not.
To the uncertainty and unintended consequences of the previous rule, they added further uncertainty and unintended consequences. Nevermind that such a rule would limit competition for deposits (Chinese banks are for now forbidden to compete on price – this is about to change –, but can well use other means and advantages). A larger deposit inflow could well happen for any reason (run on a competitor, or simply good news about the financial strength of a bank leading to an inflow of new customers). Penalising banks for such reason sounds rather dubious to say the least.
One of the consequences is that banks now turn away deposits…
The rule can also easily trigger instability, as the FT adds:
A light-hearted commentary circulated among bankers on social media on Wednesday, carrying the headline “If there’s a bank you hate, send them all your money before 12 tonight”.
I’m sure Chinese people, with their usual banking rule-avoiding ingenuity, will soon enough find a way to use all the loopholes created by this combination of definitely very clever regulations. And that regulators, in turn, will come up with another rule to patch the rule that patched the rule. The Frankenstein experiment continues.
China as a spontaneous finance Frankenstein
China is an interesting case. Underneath its very tight government-controlled financial repression hide numerous financial experiments aimed at bypassing those very controls. The Chinese shadow banking system is now a well-known financial Frankenstein, with multiple asset management companies, wealth management products and other off-balance sheet entities providing around half the country’s credit volume. The more the government tries to regulate the system, the more financial innovation finds new workarounds and become increasingly more opaque.
Bitcoin is following this typical mechanism. China was one of the world’s most successful Bitcoin markets as local retailers and customers attempted to avoid government control and manipulation. In short, Chinese users liked that Bitcoin had fixed rules that could not be twisted by some corrupted officials. Bitcoin allowed them to transfer currency internationally almost without restriction. Its Chinese supporters felt free. Indeed, freedom and facilitation of transaction and saving is what drives most spontaneous financial innovations. Nonetheless, the love story couldn’t last as I have already described and the government launched a crackdown on Bitcoin in December.
Nonetheless, Bitcoin is coming back, the Frankenstein way. The FT reported today that local Chinese Bitcoin exchanges are now finding ways around new government rules. Surprising? It shouldn’t be. Governments around the world, a simple message: don’t underestimate your citizens. You’ll always run after them. Never ahead.
The issue is now that all those rules are pushing Bitcoin and other innovations even more into the shadows, making the whole system even more opaque and hard to analyse. For instance, while Chinese banks are now forbidden to clear Bitcoin transactions, a local platform route the money through its founder’s account. Some others have started to use voucher systems, essentially transferable claims on RMB accounts for people who want to buy and sell Bitcoins. Those vouchers effectively become claims on claims on money, or some sort of money substitutes redeemable on money substitutes (bitcoins) redeemable on money (USD)…
I personally don’t really welcome such evolutions. Government should stay away and not add further systemic risks to innovations already trying to figure out what their own limits are. As I recently said, learning is intrinsic to any system and should not be suppressed.