Financial markets continue to be affected by the broad-based re-pricing of risk and de-leveraging set in train by rising levels of default in the US sub-prime mortgage market in the second half of 2007. Uncertainty about banks' financial positions and the associated loss of market confidence have led to a sharp reduction in liquidity in some credit markets, ongoing strain in money markets and a tightening in availability and standards of credit to households and companies.
Global financial stability map
Banks have continued to hoard liquidity due to concerns about their own liquidity positions and their confidence in counterparties. These risks were highlighted by the decision by US securities house Bear Stearns to seek secured funding from JP Morgan Chase & Co. and the Federal Reserve Bank of New York in March.
Whilst there have been tentative signs of a limited recovery of financial activity in some credit markets since March, central bank lending surveys suggest tight credit conditions are likely to persist. Interbank funding markets remain under considerable pressure, though there have been some improvements since March following actions by major central banks.
Since the early 1990s, safeguarding financial stability has become an increasingly dominant objective in economic policymaking, as illustrated by the financial stability reports published by more than 50 central banks and several international financial institutions as well as by the more prominent place given to financial stability in the organizational structures and mandates of many of these institutions.
During the past several decades, significant structural changes in financial systems have been associated with the expansion, liberalization, and subsequent globalization of financial systems, all of which have increased the possibility of larger adverse consequences of financial instability on economic performance. The for major trends:
- Expansion of financial systems relative to the real economy.
- Changes in the composition of financial systems.
- Increased integration of financial systems.
- Greater complexity of financial systems.
As illustrated previously there was no extensive agreement on the practicality of financial stability. Few authors rather delineated financial instability than stability. On the other hand a few others focused stability as an issue of managing system risks rather than its sustainability and its motives of financial stability.
Definition of Financial Stability
In reference to the introduction financial stability can be defined as "a situation in which the financial system is capable of satisfactorily performing its three key functions simultaneously" (Schinasi, 2006).
Initially the financial system is being initiated in the most effective way which effortlessly aids the inter temporal allocation of all resources starting right from the savers to the investors and on the whole broadly distributing the economic resources (Chant et al ,2003). Secondly spotlighting the financial risks involved which are further gauged and priced reasonably and accurately to avoid further risks and commence superior execution. Thirdly it is the factual financial and monetary revelations and shocks (Philip D., 2002).
These key factors are to be sustained on a long run, on deterioration on achieving any of the key factors would depict the downfall of its stability of its financial system and at one point would exhibit total instability (Bundesbank, 2003). For instance, inefficiency in the allocation of capital or drawback in the risks involved in pricing could be a huge setback on imbalances, vulnerabilities which could compromise on future financial system stability (Ferguson, 2002).
All these three of these aspects of the definition can and do encompass both endogenous and exogenous elements. For example surprises are termed to be an impinge on financial stability that can commence both from within and from outside financial systems (Haldane, 2004). Moreover, the inter temporal and forward-looking aspects of this particular definition of financial stability emphasize certain threats to financial stability that arise not only from shocks or surprises but there is possibility of disorder adjustments of imbalances that have built up endogenously over a time due to expectations of future returns that were misperceived and therefore mispriced (Large, 2003).
Analytical features and implications
There are several analytically featured implications in reference to the definition of financial stability that create an impact on further consideration (Abadic, 2008). On achieving it these analytical characteristics tend to endow the conceptual muscle that are required for better realization of the nature of financial stability challenge which are also an obligation for designing the practical framework for conserving financial stability which has been developed and undergone several scrutinization.
Facilitation of Real Economic Processes
Evaluation and the upshots on performance of financial system is principally on how excellent is financial system in facilitating economic resource allocation, provides savings and instigates investment process which creates an overall impact on economic growth (Angelides et al, 2009). The links on either ways create a negative impact on the real economy. To be more precise the real economy can be affected by the financial system and the performance of the financial system can be affected by the performance of the real economy. According to Paul (2009) the framework employed for assessing financial stability must take heed of these tow way links.
For example :
The financial assets of US from 1989 to 2007
Both the global scale of the recession and the policy responses under way some of which have inadvertently promoted "financial protectionism" are likely to reverse this trend, at least for the foreseeable future. The unwinding of global macroeconomic imbalances, the increase in risk aversion, and the retreat of global financial institutions and institutional investors to their home countries are likely to reduce cross border financial integration in the near term.
Moreover, stricter financial regulation and the reposition of capital controls in some countries to deal with the crisis may keep financial globalization at bay for some time, particularly if these actions are accompanied by broader protectionist measures.
Financial stability is a wide concept, comprising the different parts of the financial system infrastructure, institutions, and markets. Since there is a relative link between these components, a minute disorder in one of the components would affect the stability on the whole, therefore it necessitates a systematic outlook. Consistent in reference to the definition of the financial system, at any given time, stability or instability could be the result of either private institutions and actions, or official institutions and actions, or both simultaneously or iteratively.
Mutual Independence of Financial and Monetary Stability
Financial Stability not only necessitates financial system to adequately accomplish its role in allocating resources, transforming and managing risks, mobilizing reserves and aid over wealth accretion and expansion .It is also necessary that we need to sustain the flow of payments across official and private, retail and whole sale, and formal and informal payment mechanisms, for the smooth functioning of the economy. For the smooth functioning of the economy, it is essential that central bank such as demand deposits and derivative money which are other accounts, need to satisfactorily fulfil their role in terms of payments and sustain their unit of account appropriately to uphold a short term value.
Preventive and remedial Dimensions of Financial Stability
To maintain financial stability it is required to diminish financial crisis and lessen the possibilities that limit the effort to confront emergence of imbalances before they create any threat to stability. In a well functioning and stable financial system, this occurs in part through self corrective, market disciplining mechanisms that create resilience and that endogenously prevent problems from festering and growing into system wide risks. In this context, there may be a policy choice between allowing market mechanisms to work to resolve potential difficulties and intervening quickly and effectively through liquidity injections via markets, for example to restore risk taking or to restore stability. Thus, financial stability has both preventive and remedial dimensions.
Money, Finance and the economic system
During the assessment of financial stability issues it is necessary to consider certain characteristics of finance that differentiate it from other important economic processes such as production, exchange, saving and investment like monetary economies .Even though economic processes employ few or all the characteristics of money , the term finance is uniquely related to money. Thus it is evident that finance plays a very important role in facilitating economic processes. Identifying these unique aspects of finance facilitates the externalities of financial stability.
The following graph shows the income levels of the country or the financial integration by country income.
Understanding financial stability -towards a practical framework.
Safeguarding financial stability is now widely recognized as an important part of maintaining macroeconomic and monetary stability and a key to the achievement of sustainable growth. In several highly developed countries central bank as well as the international monetary fund allocate substantial resources to monitor and assess financial stability and publish the final financial stability reports.
Finance is basically unlike from other economic functions such as exchange, production and resource allocation. It also contributes to other economic role and amenities that initiated economic growth, increases efficiency rate which would increase social affluence .Financial stability is well known as a very important social objective amongst the community even though it is not in parity with the monetary stability pattern. Monetary and financial stability are closely related.
Why financial stability issues have recently become essential.
Ever since the early 1990s, safeguarding financial stability has become an increasingly dominant objective in economic policymaking .As illustrated by several financial stability reports published, more than 50 central banks and several international financial institutions have given the most prominent place to financial stability in the organizational structures and has made it a mandatory in many of the institutions.
In the past several decades, a significant structural change in financial systems has been noticed that has been associated with the expansion, liberalization, and subsequent globalization of financial systems. All these features have increased the opportunities for larger and adverse consequences of financial instability on economic performance.
The four major trends are expansion of financial systems related to the real economy, changes in the combination of financial systems, increased integration of financial systems and greater complexity of financial systems.
Expansion of financial systems relative to the real economy
Financial systems have expanded at a significantly higher pace than the real economy. In advanced economies, total financial assets now represent a multiple of annual economic, total financial assets now represent a multiple of annual economic production (Gale, 2000).
The growth of assets in the equity and bond markets is just remarkable. The differences in these assets between countries depict that the more market or bank oriented financial systems, most aggregates would be increased. The wide measures of an economy's total financial assets invariably involves some add-ons due to which it would maintain between financial institutions even though these mutual holdings are relevant for financial stability, they represent the links, interactions, and complexities in the financial systems (Calomiris, 2000).
Changes in the composition of financial system
During the course of financial expansion it has been noticed that financial system has been associated by several changes in its composition, along with a declining share of monetary assets aggregates (Berglof et al ,2006). An increasing share of nonmonetary assets and by implication increases the power of the monetary base.
Greater Complexity of financial systems
In terms of intricacy of financial tools financial systems have turned up to be complex. In has increased diversity in the activities and mobility risks have been also associated (Gale, 2004). Deregulation and liberalization had created various possibilities and opportunities for financial innovation and have contributed extensively into enhance the mobility of risks. As a whole this has lead to several complications ,to be more precise there was an increase in risk transfers which has made it more difficult for market participants , supervisors and policy makers to tract the developed of risks within the system in a period of time (Borio, 2003).
The Conceptual Challenges
The system calls for more systematic method for assessing the sources of financial risks and vulnerabilities. A more disciplined procedure is essential through which key concepts could be defined more precise and practical enough to measure the grade of financial stability or instability which is required to be developed in course of time to maintain the internal consistency (Rajan, 1998). Dogherty (2006) states that the challenges of assessing risks and vulnerabilities in financial systems, as well as the likelihood of threats financial stability can be likely be asked to geophysicists who come up with reliable models for predicting earthquakes, with the obvious additional complexity that finance involves human trust, decisions, and fallibility (White, 2004). The assessment of risks and the identification of financial vulnerabilities require an analytical framework.
The Financial Stability Challenge
We could characterize the challenges countered in the process of achieving, preserving and maintaining financial stability. Moreover the changes are depicted and to a certain extent on basis of structure and maturity of economic system which has been
To mature financial systems, the financial stability challenge can be characterized as maintaining the smooth functioning of the financial system and its capabilility facilitate and support the efficient functioning and performance of the economy (Cruickshank, 2000).
To achieve financial stability, it is necessary to have in placed mechanisms designed to prevent financial problems and becoming systemic and or threatening the stability of the financial and economic system, while maintaining or not undermining the economy's ability to sustain growth and perform its other important functions (Levine, 2005).
There are two vital reasons as to why challenge is not a necessary criterion to prevent financial issues from budding.
Firstly, it would be not practical enough to expect efficient, dynamic and effective financial systems could evade instances of market, such as market volatility and turbulence which all financial institutions could be capable perfectly manage the uncertainties and risks involved in providing financial services and enhancing financial stakeholder value.
Secondly it would be inappropriate to create and impose mechanisms that are overly protective of market stability or overly constraining the all of the risk taking causes of financial institutions. Constraints could be so intrusive and inhibiting that they could reduce the extent of risk taking to the point where economic efficiency is not been exhibited. However, the mechanisms of protection or insurance could be of poor designs and implemented, of which would create the moral hazard of even greater risk taking (IMF, 2004).
A very important aspect of the challenge of financial stability is to maintain its economy's ability to sustain growth and perform in its other important function. However the challenge of financial stability analysis and policymaking is that maintenance of financial stability must be balanced against other and perhaps higher priority objectives, such as economic efficiency. Finance is not a deadline by itself but does plays a supporting role in improving the ability of the economic system to perform its functions (Schioppoa and Tommaso ,2004).
The challenge of financial stability is therefore, a balancing act. It is a likelihood of systemic problems that could be limited in practice by designing a set of rules and regulation that have been restricted financial activities in such a way that the incidence or likelihood of destabilizing asset price volatility, asset market turbulence, or individual bank failures could be eliminated. But it is also likely that this type of stability would be achieved at expense of economic and financial efficiency (Rajan and Raghuram ,2005).
FINANCIAL STABILITY, SYSTEMIC RISK AND POLICY
Financial stability, instability and systemic risk
The financial system constitutes intermediaries and market infrastructure. Intermediation can be vitiated by financial instability. Moreover the financial instability can also wipe out wealth by disrupting investment, consumption and growth. The stability of a financial system depends whether it can resist external shocks and extricate financial imbalances without worsening investment and macroeconomic activity (Baur ,Schulze ,2005).
Financial instability refers to an unstable equilibrium where radical changes take place due to small disturbances. According to Bis (2005), a related depiction of an unstable financial system concentrates on whether it is close to the emergence of a discontinuity, where a shock would lead to a "jump" to a crisis state. Financial imbalance or investor's mismanagement of risk can give rise to an unstable equilibrium or a discontinuity (European Central Bank ,2004). Though the financial system is far from crisis, a prominent shock may cause interruption in the smooth functioning of the financial system.
Financial crises, their anatomy and macroeconomic implication
The reason of systemic financial crisis may be systemic risk. Financial crisis can be characterised as the sequence of financial market volatility as a result of substantial illiquidity problems and insolvency among the participants of financial market.
Omarova and Feibelman (2009) suggested that, a generalised fall asset price leads a crisis to its full dimensions which hit both markets and institutions. A rigorous aggregate shock may knock off-balance the financial system, so it's not easy to establish causality always. It is usually found that systemic financial crisis have strong negative effects on the real economy. Firms and households face increased financing costs as a result of falling prices on assets. Due to banks default the overall capital of the bank becomes limited, hence credit creation process may grind to stop. Consumption, investment and overall growth go down due to the crisis. The extremity of a financial crisis should be measured by its real effects.
Sources of financial instability: shocks, imbalances and transmission channels
According to the definition financial stability exists in financial institutions and markets in the financial system, but at the same time non financial firms, household and the macro economy are relevant. Financial stability and crisis can be caused by failure to repay the debts by firms and household (Goddard et al, 2009). It might also occur from a mere fear of such a failure.
It can be deduced that financial instability arises due to the shock from both inside and outside the financial system. An example of financial crisis due to inside shock is the failure of a large and complex financial institution, such as a major clearing bank or hedge fund due to firm specific events (Tenev, Zhang and Brefort, 2002). Example of a crisis occurring due to outside shock is a stern downturn or an excessive increase household debt followed by a wave of insolvencies.
Most shocks such as bank failures which causes financial instability from inside the financial system arises at the microeconomic level. A macroeconomic development which causes financial instability from outside the financial system may cause either individual failures or systemic crises contingent on the severity (Tadesse and Solomon, 2001). To know whether a financial instability is caused by microeconomic factors or macroeconomic factors a deeper identification is required as it is difficult to distinguish both the factors.
Financial instability and policy responses
Shocks, imbalances and transmission mechanisms must be taken into account while studying financial stability. Some questions should be considered while designing financial policies such as: when an imbalance or shock is severe enough to jeopardize the financial stability significantly? Which channels are more likely to intensify instability? Whether the future shocks identifiable? Answer to these questions can restrict systemic risk and financial crisis (Athanasoglou et al, 2008). So even if the procedure is expensive, it is preferable to respond to these questions which will help in the long run. So the regulation should be designed with a view to limit the severity of instability (Yaseen,2006). So different points should be considered such as; which shock might take place, what are the possible ways to evade them, how to make financial system more strong, what possible weaknesses in the structure of financial system could be a cause of instability and how they can be prevented, and finally how to restrict the magnifying effects by influencing the transmission channels.
The international dimension
Financial crisis in the international market goes over the national borders and it interrupts the market capacity to allocate capital globally. The relevant shocks, imbalances and transmission mechanisms get broaden in such international dimension. In a cross border dimension the instability raises alarm if it has the capability to affect one or more industrial countries materially (Riachi, 2007). Therefore, emerging market countries are out of the realm, but it should be kept in mind that systemically important shocks can arise apparently from some unlikely sources. Some concepts relating to the financial stability and systemic risk are discussed below.
Liquidity plays a vital in the context of financial stability, but it has got different meanings in different circumstances. There are three different important concepts of liquidity relevant to the financial stability (Barth, 2006). The first concept is the financial market liquidity. A market is said to be liquid if assets can be exchanged easily by agents at a low transaction cost "including bid-ask spreads" and with limited impact of price. The second concept is the funding liquidity. Funding liquidity refers to the simplicity or ease in which firms can finance their activities. Liquidity conditions for funding should be enough while the rates of interests are low, banks are in a position to extend credit and markets are big and developed (Baur and Schulze, 2005). The last concept is the Macroeconomic liquidity which refers to the expansion of credit, money and savings. It is sufficient when monetary policy is cooperative, money and credit inflate rapidly and official interest rates are low. It can also be good enough when there is more inclination towards saving, whether nationally or globally.
The connection between traders funding liquidity and asset market liquidity may cause financial instability(Beck et al, 2007). Trader's ability to offer market liquidity depends on their funding availability which depends on the market liquidity of the assets. Consequently liquidity spirals can be found in which market liquidity dries up. On the other hand it also relates to financial stability. Due to lack of market liquidity financial market can crash. As a whole it can be said that limited market liquidity is often a threat to stability, whereas sufficient market liquidity have a propensity to stabilise it (Roland, 2007). In normal times markets are highly liquid, but in difficult times the market participants rely on high liquidity to carry on which creates instability. Financial stability majorly depends on funding liquidity. Investment booms and asset price bubbles arise due to funding liquidity in excess which can lead to instability. On the contrary restrictive funding liquidity can confine market liquidity. As a result it can strengthen instabilities among financial institutions. The effect of the financial crisis can reach up to the real economy and nonfinancial firms. According to Yingyi (1999), the microeconomic liquidity can endorse the under pricing of risk whereas macroeconomic liquidity in excess can raise the risk of inflation which can lead to future cumulative shocks due to distortion in asset prices.
The spreading of financial instability is affected by the level of connection among different financial assets, financial institution and financial system (Solomon, 2001). The level of connectivity in the financial systems of major industrial and emerging market economies increases due to the growing integration of markets, institution and systems. International financial integration is one of the aspects of connectivity. A problem is prone to spread more internationally if the valuations of assets of various countries are related closely. The same thing also applies to other financial institutions (Brefort, 2002). A financial disorder is likely to spread across the system if the banks, insurers and other intermediaries are integrated closely. If the banks consolidate and spread out their operation overseas, the impact of a single failure on the domestic and international financial system will be bigger.
Leverage means the opportunity of magnifying wealth by investing borrowed finances. One of the benefits of leverage is that it makes it possible to finance a huge number of profitable investments. The leveraged investments are always riskier than the non-leveraged ones. The leveraged investments not only magnify the profits, but also the losses (Schmeits, 2005). In the corporate sector increased leverage, despite having the positive impact on efficiency and growth may create fragility. Firms with higher gearing ratios are more at risk to rising interest rates. So the stability depends on the proportion of the gearing that is debt to equity ratio in a firm.
Current risks to international financial stability
Past data suggests that any major systematic crisis arises either from a microeconomic or a macroeconomic source. For instance the great depression started from a macroeconomic origin and spread globally through both financial markets and trade (Vives, 2005). Another example is the 1980s debt crisis, which was originated from a macroeconomic source for individual countries, was also grounded in structural characteristics of the credit markets.
Existing and potential imbalances
Out of the many potential imbalances in the international financial system excess macroeconomic liquidity is a major potential imbalance which also creates funding liquidity. "Liquidity glut" have got a lot of sources (Tomasso, 2004). One of the reasons is the relatively low interest rates in industrial countries for a long time. Along with it the monetary growth and credit aggregates could be the reason which allows investors to invest in projects even with negative net present value.When monetary policy changes, the financial markets show indication of distress. Funds channel into international system when there is excessive savings of domestic investment opportunities in the local financial undeveloped market. To evade the appreciation of local currencies foreign exchange market intervention is necessary, but it creates reserve accumulation and domestic inflationary pressures (Delis et al, 2008). Distortions in policy may occur due to large volumes of carry trades which may cause imbalances. The carry trade might be just a sign of macroeconomic liquidity in excess. It is not a matter of concern if the liquidity bubble pops as only a few traders will lose money, but a large scale distortion could have a powerful impact. When the markets move towards uncovered interest rate parity it is not profitable to finance in low interest rate currencies and investing in high interest rate currencies. The uncovered interest parity can not be fulfilled according to the empirical study and it is not even essential to do so for the international financial stability. Acording to Schipani, Cindy and Liu (2002), the carry trades may be reversed with a change in exchange rate expectations or the return of exchange rate volatility. International financial stability is the result of macroeconomic imbalances irrespective of whether these are global, national or regional.
A sudden re-pricing of risk can bring shocks to the international financial system. It raises the low risk premium and spreads to a more normal level(Xenidis, 2009). Richard (2008) observed in the summer of 2007 that this kind of circumstances emerges where in certain fixed-income securities the yield achieved a higher level. Various numbers of mortgage-backed and asset-backed securities, credit risk transfer instruments and derivatives are available in the market. These quantity are so high in number that revelation of any substantial mispricing in the market can have significant effects on the balance sheets. Complex models are used for the pricing of many of these assets. Most of these assets are held rather than traded with the exception of forced liquidation. Even though market prices exist, illiquidity can persist in the market and any forced sale can have a major impact on price. A substantial decrease in market liquidity in the international financial market can give rise to another kind of systemic risk. Bundesbank (2003) identified that alteration in pricing of complex financial instrument can also inflame such systemic risk. Collapsing of a large and complex financial institution might be followed by market liquidity shocks.
Financial instability can disperse to the real economy as well as to the financial system in various ways. The impact of financial integration as per the theory is equivocal on financial stability. Stability can be increased by improve risk sharing and enhancing the market liquidity through integration (Paul, 2009). A practical question is that which of these two effects overshadows. Due to this reason importance is given to the relation between international financial stability and cross-border financial integration. Financial instability has considerably affected by financial development. It can give rise to the spreading of risks in the economy. For instance access is given to the households to better, but riskier financial instrument (Trujillo, 2007). Therefore they share a bigger proportion of their risks. New credit markets give permission to the bank to transfer credit risks to other financial intermediaries. Some of these intermediaries transfer risk to individual investors including house hold and to institutional investors. So in the process of transmission of financial instability the household plays a much bigger role.
Financial regulationsare a form ofregulationor supervision, which subjectsfinancial institutionsto certain requirements, restrictions and guidelines, aiming to maintain the integrity of the financial system. This may be handled by either agovernmentor non-government organization
In most cases, financial regulatory authorities regulate all financial activities. But in some cases, there are specific authorities to regulate each sector of finance industry, mainlybanking,securities,insuranceandpensionsmarkets, but in some cases also commodities, futures, forwards, etc. For example, inAustralia, theAustralian Prudential Regulation Authority(APRA) supervises banks and insurers.Australian Securities and Investments Commission(ASIC) is responsible for enforcing financial services and corporations laws.
Sometimes more than one institution regulate and supervise banking market, normally because, apart from regulatory authorities, Central Banks also regulate banking industry. For example, in USA banking is regulated by a lot of regulators, such theFederal Reserve System, theFederal Deposit Insurance Corporation, theOffice of the Comptroller of the Currency, theNational Credit Union Administration, and theOffice of Thrift Supervision. The structure of financial regulation has changed significantly in the past two decades, as the legal and geographic boundaries between markets in banking, securities, and insurance have become increasingly "blurred" and globalized.
In addition, there are also associations of financial regulatory authorities. In theEU, there are the Committee Of European Securities Regulators (CESR), the Committee of European Banking Supervisors (CEBS) and the Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS), which are Level-3 committees of theEuropean Unionin theLamfalussy process. And, at a world level, we have theInternational Organization of Securities Commissions(IOSCO).
The Current Structure of Financial Regulation
The PBC is the central bank in China, a role legally confirmed by the Law of PRC on the People's Bank of China (PBC Law).13 Pursuant to the PBC Law, the PBC must formulate and implement monetary policies, guard against financial risks and maintain financial stability under the leadership of the State Council.
As with most central banks in the world, the PBC performs a threefold role: as the currency-issuing bank; as the bank of banks; and as the government bank.15 More specifically, the PBC issues the Chinese currency, namely Renminbi, and serves as a bankers' bank for other banks and financial institutions. It seeks to stabilize the currency and the financial system by indirect, macro-economic means rather than through a direct, interventionist approach as it did in the planned economy era. It therefore exercises macro-economic control over the financial markets primarily through monetary tools such as deposit reserves, rediscount rate, interest rate and open market operations.
Apart from the central bank, there are several different types of institutions in China's banking system, including state-owned commercial banks, other commercial banks, policy banks, non-bank financial institutions.
The first category comprises the so-called 'Big Four' state-owned commercial banks, including ABC, BOC, CBOC and ICBC. As noted before, these banks were previously specialized banks but now are all developing into comprehensive commercial banks. Due to their historical background and strong foundation, they are very large with huge client base and together command the lion's share of the market in terms of public savings, deposits and loans.17 Second, there are three state-owned policy banks, including the China Development Bank, the Agricultural Development Bank of China, and the Export-Import Bank of China. As discussed earlier, these three banks were established in 1994 to take over the provision of policy loans from the 'Big Four' banks.
Third, an increasing number of other commercial banks have sprung up like mushrooms since the late 1980s. They include joint-stock banks like the Merchant Bank and the Minsheng Bank. A common feature of these banks is that they are small or medium-sized and relatively efficient. Further, there is a residual group of banking or non-banking financial institutions engaged in deposit-taking and lending business such as urban commercial banks, urban/rural credit unions, and post office savings units. Finally, foreign banks like HSBC and Citibank have played an increasingly important part in the market, especially after China's WTO entry.
In 2003, the CBRC came into existence as the banking 'watch dog', taking over the role previously performed by the PBC. The legal and regulatory framework for banking regulation comprises the Law of the PRC on Commercial Banks,18 and the Law of the PRC on Banking Regulation and Supervision.19 Like its peers in the securities and insurance markets, the CBRC is a ministry rank unit under the direct leadership of the State Council.
There are two important points to note about the CBRC. First, the CBRC regulates not only banks, but also a variety of specified non-bank financial institutions. The former group covers those banks discussed above, such as commercial banks, policy banks, urban/rural credit unions, and other financial institutions engaged in taking deposits of the general public. The latter group includes financial assets management companies, trust investment companies, financing companies, financial lease companies and other financial institutions established with approval of the CBRC.20 Second, the CBRC is responsible for both market conduct regulation and prudential regulation in relation to the financial institutions it regulates.21 In practice, the CBRC exercises its supervisory function through prudential standards such as asset/liability ratio requirement, capital adequacy ratio and risk management, as opposed to the more interventionist means like the imposition of loan quotas as used under the planned economy.
As noted earlier, commercial insurance activity was resumed in China in 1980 when the PICC was reopened for business. In recent years, with the rapid progress of the social security reform, the insurance market has been growing by leaps and bounds in China. As at the end of 2007, there were 110 insurance companies, in comparison with 52 in 2002; their overall business volume hit a record high of 703.6 billion yuan, more than twice the figure of 2002, and their overall assets were worth 2.9 trillion yuan, representing a four-fold increase from 2002.22 In terms of market capitalization, the China Life Insurance has now become the largest listed life insurance company in the world.23 Consistently with its WTO commitments, China has expedited the opening up of its insurance market, up to 134 business offices being established in China by 43 foreign insurance companies from 15 countries and regions at the end of 2007.
Against the backdrop of the fast-growing insurance market, the regulatory regime has been reformed over the years. The CIRC was set up in 1998 to assume regulatory responsibility for the insurance industry in China under the Insurance Law of the PRC.25 Like the CBRC, the CIRC is charged with both market conduct regulation and prudential regulation in relation to insurance companies.
Originally as a crucial tool to rescue the financially ailing SOEs, the securities market has been given much development priority by the Chinese leadership and thus has experienced rapid growth.26 There are currently two national stock exchanges located in Shanghai and Shenzhen respectively, both being non-for-profit membership-based organizations. By the end of 2007, the two exchanges were handling an aggregate of 1,550 listed companies with a market capitalization of 32.7 trillion yuan, accounting for over 50% of China's GDP.
One distinctive feature of the Chinese stock market is the segmentation of the market. There are several different types of shares, distinguished by rules governing their ownership and trading. First, depending on the nationality of eligible traders and the currencies in which the shares are traded, there are traditionally two broad types of shares in the market: A-shares and B-shares. A-shares are basically limited to domestic investors while B-shares designed for foreigners. Further, some Chinese companies are crossed-listed on overseas exchanges and their shares listed there are named after the exchanges. For instance, H shares are shares listed on the Hong Kong Stock Exchange while N shares on the New York Stock Exchange.
Process of financial regulation
- Step One: Taking Inventory
- Step Two: Assigning Priorities, Identifying Rules
- Step Three: Designing the Architecture, Dividing Responsibilities
It may be possible to anticipate many of the conclusions of this inventory-taking exercise, and the recent proposals for financial regulatory reform go far in this direction. The first global financial crisis of the twenty-first century has made it abundantly clear that the business and risk profile of today's financial services industry has changed significantly since the 1930s, when the basic framework of the U.S. financial regulation was put in place. Various structural factors, including increasing globalization of financial markets, growth of large financial conglomerates with International operations, convergence of financial products and services traditionally offered by institutions separated by sectoral lines, and rising importance of institutional investors, have rendered many of the traditional regulatory boundaries among different categories of financial institutions such as commercial banks, thrifts, securities and insurance firms, etc., largely meaningless and inefficient This initial step involves taking an inventory of the financial institutions and key market participants with the goal of developing a thorough, concrete, and up-to-date picture of the financial industry's composition and operation in the wake of the crisis
The approach advocated here would allow policymakers to move beyond a retrospective stance and place these crucial questions in a proper empirical context. There are real dangers to identifying an appropriate regulatory philosophy before embarking on a systematic quest to understand the emerging financial services landscape. A regulatory philosophy should, ideally, emerge gradually and organically from the analysis and synthesis of the industry data gathered at an initial stage and the assessment of the effectiveness and proper scope of substantive rules and regulatory techniques. Thus, for example, the right balance between top-down regulatory prescriptions and mandates, on the one hand, and bottom- up private industry self-regulation and self-monitoring, on the other, may differ across segments of the financial services sector. Finding such balance depends fundamentally on the dynamics and risk profiles of individual industry segments (as defined during the first stage of the reform process), as well as the policy objectives and regulatory techniques designed to address the risks specific to each such segment.
At this final stage of the reform process, it will be useful to critically examine the various existing approaches to the structure of financial regulation and supervision.148 Generally, these include institutional/functional, integrated, and "twin-peaks" approaches.
The Global Financial Crisis -- a Behavioral View
The termfinancial crisisis applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated withbanking panics, and manyrecessionscoincided with these panics. Other situations that are often called financial crises includestock market crashesand the bursting of other financialbubbles,currency crises, andsovereign defaults.Financial crises directly result in a loss ofpaper wealth; they do not directly result in changes in the real economy, may indirectly do so, notably if a recession or depression follows.
When a bank suffers a sudden rush of withdrawals by depositors, this is called abank run. Since banks lend out most of the cash they receive in deposits (seefractional-reserve banking), it is difficult for them to quickly pay back all deposits if these are suddenly demanded, so a run may leave the bank in bankruptcy, causing many depositors to lose their savings unless they are covered by deposit insurance. A situation in which bank runs are widespread is called asystemic banking crisisor just abanking panic. A situation without widespread bank runs, but in which banks are reluctant to lend, because they worry that they have insufficient funds available, is often called acredit crunch. In this way, the banks become an accelerator of a financial crisis.
Examples of bank runs include therun on the Bank of the United States in 1931and the run onNorthern Rockin 2007. The collapse ofBear Stearnsin 2008 has also sometimes been called a bank run, even though Bear Stearns was aninvestment bankrather than acommercial bank. The U.S.savings and loan crisisof the 1980s led to a credit crunch which is seen as a major factor in the U.S. recession of 1990-91.
Speculative bubbles and crashes
Economists say that a financial asset (stock, for example) exhibits abubblewhen its price exceeds the present value of the future income (such asinterestor dividends) that would be received by owning it tomaturity.If most market participants buy the asset primarily in hopes of selling it later at a higher price, instead of buying it for the income it will generate, this could be evidence that a bubble is present. If there is a bubble, there is also a risk of acrashin asset prices: market participants will go on buying only as long as they expect others to buy, and when many decide to sell the price will fall. However, it is difficult to tell in practice whether an asset's price actually equals its fundamental value, so it is hard to detect bubbles reliably. Some economists insist that bubbles never or almost never occur.
Well-known examples of bubbles (or purported bubbles) and crashes in stock prices and other asset prices include the Dutchtulip mania, theWall Street Crash of 1929, theJapanese property bubbleof the 1980s, the crash of thedot-com bubblein 2000-2001, and the now-deflatingUnited States hou
International financial crises
When a country that maintains afixed exchange rateis suddenly forced todevalueits currency because of aspeculative attack, this is called acurrency crisisorbalance of payments crisis. When a country fails to pay back itssovereign debt, this is called asovereign default. While devaluation and default could both be voluntary decisions of the government, they are often perceived to be the involuntary results of a change in investor sentiment that leads to asudden stopin capital inflows or a sudden increase incapital flight.
Several currencies that formed part of theEuropean Exchange Rate Mechanismsuffered crises in 1992-93 and were forced to devalue or withdraw from the mechanism. Another round of currency crises took place inAsia in 1997-98. ManyLatin American countries defaultedon their debt in the early 1980s. The1998 Russian financial crisisresulted in a devaluation of the ruble and default on Russian government bonds.
Wider economic crises
Negative GDP growth lasting two or more quarters is called arecession. An especially prolonged recession may be called adepression, while a long period of slow but not necessarily negative growth is sometimes calledeconomic stagnation.
Since these phenomena affect much more than the financial system, they are not usually considered financial crisesper se. But some economists have argued that many recessions have been caused in large part by financial crises. One important example is theGreat Depression, which was preceded in many countries by bank runs and stock market crashes. Thesubprime mortgage crisisand the bursting of other real estate bubbles around the world has led to recession in the U.S. and a number of other countries in late 2008 and 2009.
Nonetheless, some economists argue that financial crises are caused by recessions instead of the other way around. Also, even if a financial crisis is the initial shock that sets off a recession, other factors may be more important in prolonging the recession. In particular,Milton FriedmanandAnna Schwartzarguedthat the initial economic decline associated with thecrash of 1929and the bank panics of the 1930s would not have turned into a prolonged depression if it had not been reinforced by monetary policy mistakes on the part of the Federal Reserve,andBen Bernankehas acknowledged that he agrees.
Over the past two years, we have witnessed the most severe global financial crisis since the Great Depression in the 1930s, with the failure of major financial institutions in the US and Europe. The reasons for the crisis are complex and the crisis has been attributed to an array of factors
The impact of the financial crisis in the US in July 2007 flowed into the Chinese equities market. The Shanghai Stock Exchange Composite Index started to slide from its peak of 6124 on 16 October 2007, all the way down to 1664 on 28 October 2008, representing a deep drop of up to 73% in just one year.
The International Monetary Fund's April 2009 Global Financial Stability Report (IMF, 2009) reports an estimate of $2.7 trillion for writedowns of US-originated assets by banks and other financial sector institutions between 2007 and 2010. Estimated writedowns for all mature marketoriginated assets for the same period are in the region of $4 trillion. The same report contains estimates of the implications of these writedowns for bank recapitalization. To restore bank capitalassets ratios to the average level before the crisis of 4%, the required capital injections are $275bn for banks in the US, $325bn for the euro area, $125bn for the UK, and $100bn for other mature European countries. To restore capital-assets ratios to the average level of 6% that existed in the mid-1990s, the required injections are $500bn, $725bn, $250bn and $225bn, respectively.