Vice Chairman CAI Esheng s Speech at the China Financial Summit Meeting

Vice Chairman CAI Esheng s Speech at the China Financial Summit Meeting

May 19^th

I am very glad to attend this China Financial Summit Meeting and I would like to say a few words on the topic of financial innovation and financial safety.

I. Financial innovation and financial safety in global context

As we all know, the global financial crisis was triggered by deterioration of subprime loans. At the dawn of the crisis, no one had expected the single subprime products could have produced such massive-scale shocks to financial system and economic development. In response to the crisis, the governments have introduced expansionary fiscal and monetary policy to fill the credit gap left by credit crunch. In the meantime, people have started to review the significant loopholes in the system and try to fix it to avoid the repetition of such crisis. Chinese banking sector remains strong during the crisis, which could be primarily attributed to our sound and prudential macro strategies and micro policies. Yet, we should also seize this opportunity to learn the lessons of others to make our system stronger.

1. intrinsic flaws in macro-economic structure fuels the growth of asset bubbles and foils the self-correction function.

Bubbles precede the crisis and the burst of bubbles triggers the crisis. The financial crisis is closely related to the flawed US economic structure and over liquidity issue. The evolution of crisis could be roughly divided into five stages. First, the Federal Reserve s long-term loose monetary policy created huge liquidity in the market. Due to the US upgrading its industry to upstream high-tech sectors, the liquidity did not translate into inflation immediately, but it accumulated in the economic activities. Second, the over-consumption was widespread in US. As both corporate sector and household sector were supported by huge liquidity, the overall leverage ratio continued to rise. Third, unregulated financial innovation blurred the traditional boundary between banks, insurance companies, and security firms. The OTC market became the conduit for risk contagion among different institutions. As more and more assets were transferred to off-balance-sheet by innovative techniques, the actual leverage ratio in financial institutions was increased. Fourth, the financial capital was too concentrated in real estate, energy and OTC market, which generated price bubbles. Fifth, the financial regulators were too obsessed with the market self-correction function and their supervisory tools were also lagging behind the market development. They failed to identify the bubbles and control the speculations in the market.

2. prudent operation is the corner stone of banking business

Over liquidity helped narrow the risk premium and created incentives for speculation. But the fact proves that irrational prosperity by over liquidity cannot be sustained. In the bubble-forming process, without external intervention, the market will enter into a self-validating circle to help grow the bubbles. The highly leverage institutions (hedge fund, investment banks, Fannie Mae and Freddie Mac) were hit directly and seriously. However, the most influential institutions remained to be significant banks. As banks are taking public deposits, they should be more risk averse and assume more prudential business policy and more strict social responsibility. Unfortunately, since US abolished the Glass-Steagall Act, banks started to move into risky markets (stock market and derivatives market), which in fact violated their duty of care and fiduciary duty. A serious lesson we could draw from this crisis is that banks should come back to basics, i.e. adequate capital, sound operation, appropriate liquidity positions. These basic principles appear to be more important even in the context of sophisticated financial innovations.

3. financial innovation is a double-edged sword.

Financial innovation is the institution s behavior to change its policies, procedures, and design new products and services. It is necessary to an institution s existence and prosperity. Yet, we can easily identify many non-prudent, irresponsible financial innovations during the crisis. Some of them are amplifying the risk instead of hedging it. The explosive growth of financial derivatives has gone too far from the real economy. The slicing and dicing of the financial products created serious problems like information asymmetry. In this sense, the price cannot be determined by using the traditional method, and the entire system became more likely to collapse once one of the links broke. The crisis proved that financial innovation brings both risk and rewards. Without financial innovation, the market will lose the vitality. But without effective regulation, it could produce more risks.

II. Major practices in China s banking sector innovation

Over the years, the financial innovation in China has moved prudently with more and more innovative products and services. The wealth management under the retail banking business line has grown rapidly. In 2008, 83 overseas and domestic banks sold a total of RMB 3.87 trillion products for their wealth management business. Moreover, the bankcard business, e-banking, and derivatives trading have enjoyed strong growth momentum. Pilot banks were selected to set up fund management subsidiaries, leasing companies, and take stakes in trust companies.

Despite the progress, we ought to recognize the gap between local banking institutions and their international peers in the following aspects. First, Chinese banks should establish systematic strategy and sound internal procedure; instead of simply duplicating other s practices. Second, the current innovation in the market bears strong resemblance and some products are even homogeneous. Banks should develop their capacity to identify and design niche market products. Third, banks should strengthen their risk management procedure over the entire innovation process. Fourth, banks should fulfill their social responsibility and increase their commitment to public investor education.

The financial crisis has offered us a number of lessons to learn. First, the financial innovation should aim to serve real economy and satisfy the actual tangible market demand. Second, financial innovation should be commensurate with financial system development, which includes market infrastructure, participants knowledge, risk management capacity etc. Third, the financial innovation should address the investors interests. It must be suitable in line with investors risk appetite.

III. China s approach to regulating financial innovation

One of CBRC s legal mandates is to protect fair competition and promote competitiveness in China s banking sector. And CBRC aims to balance the financial stability and financial innovation. In practice, the CBRC has mapped out a set of comprehensive supervisory principles to achieve this target.

First, the CBRC requires banks to maintain the basic principles in doing financial innovation. The cost should be calculated, risk should be controlled and information should be fully disclosed. In addition, banks should know your business , know your risk , know your customer , and know your counter-party .

Second, the CBRC stresses that financial innovation is closely related to risk management. It is necessary to put in place strong self-disciplinary procedure and internal control system to oversee the entire innovation business process.

Third, the CBRC tries to improve its own capacity building and enhance the market infrastructure. For instance, the CBRC coordinates the licensing function, on-site exam and off-site surveillance to supervise the institutions from a matrix point of view. Furthermore, the CBRC has introduced a number of policy documents to make the supervision more responsive, effective, and professional.

In the current circumstance, the CBRC encourages innovation to facilitate the credit support to real economy.

First, the financial innovation should aim to follow the national restructuring strategy. For example, we encourage the financial innovation in delivering stronger credit support to rural economy, SMEs, high-tech sectors, and consumer finance. On the contrary, banks should tighten their credit to energy-intensive and high polluting industries to reduce their risk exposure.

Second, banks should develop internal procedure to manage the risk in financial innovation. They should take a holistic approach in calculating the risk and rewards of the innovative products, and balance the short-term benefits with long-term gains.

Third, banks should be more committed to investor education. They should not only disclose risk to customers, but also deliver basic knowledge to individual and institutional investors, and help the investors to identify appropriate investment philosophy.