Chairman LIU s speech at the Caijing Magazine Annual Meeting

Chairman LIU s speech at the Caijing Magazine Annual Meeting

Addressing Challenges and Promoting Innovation: The Role of Regulators

The year 2008 is an eventful year in the world financial history. The US subprime crisis has evolved into a global financial storm, which, in turn, has caused a downturn in the real economy that has reinforced the strains in the financial system. So far, the negative impact is universal and China is not immune to it. One year ago, when there was a huge debate on whether China could decouple from the world, I said it was only a myth. Now, the Caijing Magazine is offering us a valuable opportunity to look from the hindsight and lay a solid foundation for the future.

Today, I would like to address four topics.

First, the financial turmoil and economic woes are likely to continue.

In the near-term, restoring confidence in the market remains an arduous task. Liquidity is squeezed and the volatility is high because the accurate figure of losses in financial institutions cannot be calculated due to the challenge in valuing their positions in derivatives. In this context, buying shares alone is not enough. The recapitalization and buying toxic assets should undergo simultaneously, otherwise, more losses will be revealed. My rough estimation is that the aggregate loss in this crisis could amount to USD 3 trillion, which indicates that we are still far from the bottom.

In the long-term, the de-leveraging process will be very painful. One of the key lessons we have learned is that financial institutions should not be over-leveraged. The appropriate leverage ratio should be no more than 20. However, Lehman Brothers was 30 times leveraged on its book and 20 times leveraged off its balance sheet on the eve of its bankruptcy. Therefore, as banks are de-leveraging, shrinking their balance sheet, and changing their business approaches, we predict that the economic recovery will be a U-shape at the best in stead of a V-shape.

The financial turmoil hit real economy very hard, which will further amplify the credit risk and liquidity risk in the financial sector. We have seen the global shipping business is in a deep recession, which strongly indicates the gloomy outlook of major economies across the world. In the meantime, the emerging markets are more vulnerable in front of external shocks. A number of countries are turning for the World Bank. What is worse is that some emerging markets are in stagflation as the economy is slowing down while the inflation stays high.

Second, China s banking sector is facing serious challenges as the economic growth is dwindling.

1. The deflation is looming large. Both CPI and PPI are dropping very fast from around 8.7% and 9.1% to 2.4% and 2.0% respectively. The industrial added value is seeing a year-on-year decline to 8.2%. The real estate development investment has a year-on-year growth of 24.6%, down 6.8 percentage points. The foreign trade volume is shrinking and the power demand has clearly contracted.

2. The correction in domestic assets market is likely to trigger capital outflow. The housing price has seen a consecutive monthly decline for several months. The stock market plunged over 62% and its function of providing funds for companies is seriously undermined.

Third, we should continue our reform to strengthen the banking sector.

Western countries have identified numerous reasons for the financial crisis, i.e. over trust in rating agencies, over reliance on quantitative models, defects in liquidity management, pro-cyclicality in accounting standards and capital standards and so on. But I would like to highlight five problems that should be addressed; otherwise, the mistakes that have been made this time will be repeated in the future.

1. The firewall between the banking market and capital market has been torn apart by financial innovation , which facilitated risk contagion across the board.

2. The western regulatory authorities are too obsessed with innovation and market force and have neglected the role of prudential regulation. Without sober judgment and counter-cyclical moves by the regulators, market failures will be frequent.

3. Excessive use of leverage leads to speculation. We always stress three fundamental rules for banking business. 1) each financial firm should ensure they have reliable and stable funding source. Pure reliance on inter-bank borrowing is strictly prohibited. 2) each financial firm should ensure they have strong risk management expertise, prudent business model and careful due diligence procedure. 3) each financial firm should have a qualified board and senior executive team with duty of care and fiduciary duty.

4. It is necessary to oversee the incentive schemes in financial instituitions. Regulators should not go out to set the compensation package for each senior executive, but we should ensure that the incentive scheme in each financial firm is rational and sustainable. This is important because the incentive is linked to performance. Distorted incentive package will encourage people to take excessive risks and sacrifice the long-term benefits for short-term gains.

5. There are serious defects in the rescue plan. The US bailout plan was originally for big embattled financial institutions. But many people argued that it should be used to boost the sluggish economy. Now similar debate arises in the auto industry. Therefore, to address the crisis, we must first have a broad vision, then a building block approach, and also a sequenced arrangement.

Fourth, China should avoid the mistakes made in the Western world and highlight the role of regulators.

1. Improving corporate governance. It is an appropriate time to encourage banks to improve corporate governance. The boards in Chinese banks should start to review their institutional arrangement and improve their management procedures.

2. Maintaining boundaries between businesses. The bank-based market and capital-based market should be separate. In this regard, we should maintain the current status and prevent risk contagion from capital market to commercial banks.

3. Regulating financial innovation. While financial innovation is important to manage and distribute risks, banks and regulators should have more in-depth understanding of the innovative instruments in the market. From the CBRC s perspective, we encourage banks to conduct business innovation. But we also require them to put in place sound risk control structure to ensure that they can understand and manage the risks in these new businesses.

4. Using conventional measures to supervise banks. No matter what the risk is, we should always highlight the traditional measures in managing it, namely, corporate governance, capital adequacy, large exposure, NPL ratio, provisioning coverage ratio and transparency.

5. Building a strong talent pool. At this critical juncture, it seems more important that we should have a strong professional team that is able to handle the sophistication amid the crisis. In the meantime, we should be more involved in the global supervisory cooperation and create a favorable external environment for Chinese banks.

To conclude, the crisis has brought us both challenges as well as opportunities. I wish all of us could work hand in hand to weather this financial storm and I believe that after this storm, Chinese banking sector will enjoy a brighter future.