China’s Shadow Banking System - An examination of the risks and benefits of China’s

Shadow Banking System through the lens of Competition Law, Corporate Governance and

Regulatory Banking Techniques

By

Hatim Hamed Saleem

Course: Corporate Finance Law (LLM)

Module Title: International Corporate Governance: Managing Global Risk,

Ethics and Cultures

Course Title: Corporate Finance Law (LLM)

Word count: 5000 words

Year of entry: 2013

Semester: one

Module Code: 1MVC7A1.1

To be marked by: Prof. Joseph Tanega

Student ID: 147087871

Email Address: h.saleem@my.westminster.ac.uk

Contact Number: 07503330438

Home Address: London, 199 lisson grove, 503 belvedere Hights

Postcode: WN8 8HZ

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Table of Contents

1.0 Introduction:..................................................................................................................2

1.1 Statement of Problem:......................................................................................................2

1.2 Research Questions and Rationale:..................................................................................2

1.3 Methodology:....................................................................................................................2

1.4 Chapter Outline:...............................................................................................................2

2.0 Shadow Banking in China – Legislative & Policy Concerns in the Post GFC Era:2

2.1 :.........................................................................................................................................2

2.2 The Development of Sustainable Diversification:............................................................2

2.3 A Healthy or Unhealthy Banking System?.......................................................................2

2.4 Corporate Governance, Large Scale Banking and Shadow Banking in China:..............2

2.4.1 The Mainstream Banking System:.............................................................................2

2.4.2 The Shadow Banking System and Diversity:............................................................2

2.4.3 Systemic Risk and Creating a Sustainable Framework:............................................2

3.0 Governance and Legislative Options to Remove Risk in China’s Shadow Banking System – A Comparative Case Study:....................................................................................2

3.1 Some Regulatory Options:................................................................................................2

3.2 A Proactive Model of Governance in the Shadow Banking Framework:........................2

4.0 Conclusion:.........................................................................................................................2

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1.0 Introduction:

1.1 Statement of Problem:

Shadow banking in China is big business1 and may provide the only source of competition in

its banking sector.2 This means that the issue of risk in shadow banking has to be carefully

balanced with the need for competition.3 Consequently, it is necessary to ensure that there is a

wider understanding of the shadow banking system, especially when conservatism can overly

impede the effectiveness and fairness of the international banking model.4 It is this

conservatism, which contributed to Asian Financial Crisis. The legal quandary of China’s

innovative shadow banking system will be juxtaposed with the issue of risk, as highlighted in

the Global Financial Crisis (GFC). Nevertheless, the risk of China’s mainstream banking

system will also be considered. This research will determine if China’s shadow banking

system poses the same level of risk as Western systems that have been identified as

significant contributors to the GFC. Therefore, the main problem that this research will tackle

is if a sustainable shadow banking system can be (or already is) developed in China.

In order to show the importance of a sustainable model, this research will undertake a multi-

jurisdictional case study approach. Thus, the risks of securitization and investment finance

backed mortgages will be considered as case studies, because issues on ring-fencing and

enhanced governance are centred on these issues. Ring fencing will be considered, but at this

point, it is probably unsuitable for China’s concentrated banking system. However,

1.2 Research Questions and Rationale:

The primary research question is:

Why is good governance important to China’s Shadow Banking System in its drive to

promote competition in a concentrated banking model?

This question will be broken down into four sub-questions, which will be answered in order

to answer the primary research question.

1) Is China’s shadow banking system necessary to drive competition, because of the

concentration of power in the traditional banking system?

2) Does the rapid growth in China’s Shadow Banking System pose an unsustainable

risk?1 D. Roberts “china’s shadow banking sector tops $5.8 trillion” BloombergBusinessWeek, Global Economic, MAY 08, 2013. Retrieved from http://www.businessweek.com/articles/2013-05-08/chinas-shadow-banking-sector-tops-5-dot-8-trillion-report-says accessed on 28.10.132 Shen, W. (2013) “Shadow Banking System in China – Origin, Uniqueness and Governmental Responses” Journal of International Banking and Regulation 28(1) 20-26, 213 Ibid, 234 Barton, D, Wang, Y and Ye, M “A Chinese View of Governance and the Financial Crisis: An Interview with the ICBS’s Chairman” (2009) McKinsey Quarterly 2 pp. 111, 111

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3) Can good governance within China’s Shadow Banking System fight this

unsustainable risk?

4) What form should good governance take, in order to fight this unsustainable risk?

These questions have been developed to provide a logical framework to give the data to

answer the primary research question. The four sub-questions will be answered through

inductive reasoning.5 The inductive reasoning will allow identifying a hypothesis for each of

the questions, which can then be consolidated to create a general hypothesis for the primary

research question. These hypotheses will then be tested against a case study of the

securitization and mortgage backed markets. The deduction will be based upon a qualitative

mixed methods approach,6 where literature, legislation and techniques that are applied in

China, the USA and the EU are examined to determine the validity of the hypotheses

developed. The role of deduction in this context is to ascertain if the analysis of the initial

literature, legislation and theoretical review can be proven,7 disproven or altered in the

context of specific shadow banking provisions. To simplify the case study further only Over

the Counter (OTC) products will be considered. This is a particularly short piece of research,

thus, the examination will not examine the case study in depth. Rather, it will be used for

illustrative purposes only.

1.3 Methodology:

The general methodological approach is to undertake a qualitative review of China’s Shadow

Banking System and the Shadow Banking systems in the EU (the UK?) and the US. This

review will include an examination of the structure of the Shadow Banking System in the

three jurisdictions, the different legal challenges and contexts of competition, corporate

governance and regulation. The reactions to the Global Financial Crisis (GFC) are important

in all jurisdictions, such as implementation of Basel III, the use of Ring-Fencing and changes

to the corporate governance regime. This data will be consolidated to answer the sub-

questions. The answers will then deductively tested in the case study of OTC securitizations

and mortgage-backed products. The focus of this research will be legal information, which

includes legislation, corporate governance codes and regulation.

5 Arthur, WB. “Inductive Reasoning and Bounded Rationality” (1994) The American Economic Review 82(2) 406-411, 4076 Ospina, S, “Qualitative Research”, Encyclopedia of Research 2004 (Thousand Oaks: CA: SAGE Publications, 2004). Retrieved from http://kampungtadris.files.wordpress.com/2012/06/qualitative_research.pdf accessed 31st October 2013, 37 Johnson-Laird, PN “Deductive Reasoning”, (1999) Annual Review of Psychology 50, 109-135, 112

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The social meaning will play an essential role in this examination. This is because the context

and nature of the Chinese banking system will have to be considered, most notably the

concentration of power in the traditional banking system. Therefore, the research design and

methodology will attempt to deal with the social and legal aspects of the Chinese banking

system, in order to create a sustainable Shadow Banking Model.

1.4 Chapter Outline:

The following chapter structure will be used:

Chapter Two: will examine the nature of China’s banking system, the competition issues

and why the Shadow Banking System is important. Most notably, the economic and social

rationale for the expansion in China’s Shadow Banking System will be considered. It will

also focus on China’s Shadow Banking System to determine the effectiveness of the

legislation and governance that is presently in place (i.e. is the system preventing

unsustainable risk).

Chapter Three: will examine the potential governance and legislative options that can be

used to fight any risk, in order to do this it will draw upon the post-GFC techniques that have

been used in the USA and the EU. It will then synthesise the data from the previous chapters

to answer the first four sub-questions. Deductive reasoning will be used in the OTC case

study of securitization and mortgage backed products in China’s, the USA’s, and EU’s

Shadow and mainstream banking systems.

Chapter Four: (the Conclusion) will synthesise the case study data and make a number of

recommendations on the form that good governance should take, in order to fight this

unsustainable risk.

2.0 Shadow Banking in China – Legislative & Policy Concerns in the Post GFC Era:

This will examine the nature of China’s banking system, the competition issues and why the

Shadow Banking System is important. Most notably, the economic and social rationale for

the expansion in China’s Shadow Banking System will be considered. It will also focus on

China’s Shadow Banking System to determine the effectiveness of the legislation and

governance that is presently in place (i.e. is the system preventing unsustainable risk).

2.1 The Importance of the Chinese Shadow Banking System:

China’s shadow banking system is of paramount importance to liberalisation and

competition, because it has been the framework that has enable the diversification of the

Chinese banking model.8 The traditional banking system has posed a significant obstacle to

liberalisation, because it is based upon a framework of limited competition due to the 8 Shen (n2), 21

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concentration of power.9 The concentration of power is either governmental power or focused

in the elite of ruling families of China.10 The shadow banking system is injecting competition

into a system that would otherwise remain oligopolistic.11 Thus, it is necessary that the

shadow banking system is retained, because to remove it can create a moral hazard that is no

different than engaging in excessive risk. Since the Asian Crisis of the late 1990s and early

2000s, it has been recognised that it is necessary to have a diversified banking and financial

market, because the impact of one of the banks failing or engaging in scandal could have a

devastating effects.12 This means that sustainable diversification is necessary.13 The

sustainable diversification of the Chinese banking system does lie with the shadow banking

system; however, it is necessary to develop a legislative framework that ensures a moral risk

is not created by irresponsible bankers.14

2.2 The Development of Sustainable Diversification:

In an attempt to create sustainable diversification, China is focusing on Renmibi liquidity.15

The inference is that such measures will retain the flexibility of the Shadow Banking System

whilst improving governance.16 It has been argued in different quarters of the Asian financial

markets that ring fencing should not be applied.17 Rather, a more co-operative model of

communication between the regulator and the banking system is needed,18 especially when

the risk of shadow banking system is heightened in this vulnerable period of the global

markets.19 A more appropriate response will be the focus on the Basel requirements,

especially in the light of the GFC.20 In fact, the Renmibi focus of China is being considered a

role-model approach to staving off the moral risk that has been highlighted in the GFC.21

Nevertheless, this is merely a formulistic approach, which may undermine the development 9 Ibid, 2210 Ibid, 2211 Ibid, 2212 Barton, et al (n4), 113 13 Shen, W. “China’s central bank in its post financial crisis era – understanding and rationalising its monetary policies and challenges” (2012) Journal of International Banking Law and Regulation 28(8), 300-307, 30214 Dowd, K “Moral Hazard and the Financial Crisis” (2009) Cato Journal 29(1) 14315 Shen (n2), 2316 Ibid, 2317 Schwarz, SL “Ring-fencing” (2013) Southern California Law Review 87, pp. 2, 2818 Ibid, 28-919 Wei, L and Davis, B. “China debt-crisis fears focus on shadow banks” Market Watch June 23, 2013. Retrieved from http://www.marketwatch.com/story/china-debt-crisis-fears-focus-on-shadow-banks-2013-06-25 accessed 31st October 201320 Shen, (n16),304 Shen, W “Healthy or Unhealthy? That is the Problem – Unveiling the Myth of Chinese Banks Success” Journal for International Banking Law and Regulation 28(2), 81-88, 9021 D. Kerr “Big plans in little China: Luxembourg steals a march in the race to become Europe’s renminbi centre” Retrieved from http://www.euromoney.com/Article/3262495/Category/16/ChannelPage/0/Big-plans-in-Little-China-Luxembourg-steals-a-march-in-the-race-to-become-Europes-renminbi-centre.html accessed on 28.10.13

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of sustainable protections. In addition, follow the Chinese model may be fundamentally

flawed, because it is difficult to determine if it is a healthy or unhealthy system due to the

dual framework.22

2.3 A Healthy or Unhealthy Banking System?

The Chinese banking system has a number of contradictions, which makes it difficult to

determine if it is healthy or unhealthy.23 This is in part linked to the cultural nature of the

banking model, which links to familial concentration.24 The role and rapid growth of the

Shadow Banking System have been important to diversifying the Chinese banking model, in

order to make the system internationally attractive.25 However, it has also created institutional

risk,26 which places the Chinese system at the same level of risk as shadow banking systems

that gave rise to risk that fuelled the GFC.

The problem of governance, especially due to the concentration of power in the traditional

banking system,27 means that the shadow banking system is necessary and its presence will

not result in the collapse of the China’s economy. In fact, the formulaic system of Basel

(especially Basel III) will pose a problem to the sustainability of the banking system as a

whole.28 Alternatively, too much flexibility in the Chinese shadow banking system opens up

the problem that there will be inherently risky lending (a problem that fuelled the GFC). This

has been proven by the unsustainablThe Importance of the Chinese Shadow Banking Systeme

lending to local government projects, which do not have the funding to satisfy these loans.29

The fact that shadow banking is used to fund unsuitable local government infrastructure is

creating a heightened risk, especially with the traditional concentration of family power in

local areas (i.e. these loans may fund public projects in nepotism, as opposed to

sustainability). The inference is that these necessary public projects may not be undergoing

stringent suitability check, which means that numerous failures will shock the system and

cause failure in the shadow banking system. Thus, without appropriate regulation the risks of 22 Shen (n16), 30423 Ibid, 30424 Barton et al (n4), 11225 Shen (n16), 30426 J. Li and S. Hsu “shadow banking in China: Institutional Risk” (political economy research institute, AUG 2013). Retrieved from http://www.peri.umass.edu/fileadmin/pdf/working_papers/working_papers_301-350/WP334.pdf accessed on 28.10.13 27 L. Qiaoyi and C. Tian “Shadow Banking won’t lead to collapse: IMF official” Global Times, SEP 14, 2013. Retrieved from http://www.globaltimes.cn/content/811188.shtml#.UnfDfvmkqtY accessed on 29.10.1328 L. McNulty “Why Basel III is bad for China” IFLR, MAY 09, 2013. Retrieved from http://www.iflr.com/SearchResults.aspx?Keywords=China+Basel+III accessed on 28.10.13 29 M. Zhang “China’s local government debt crisis: Through heavily leveraged and linked to Shadow Banks, provincial infrastructure spending will come just short of a hard landing” International Business Times, OCT 25, 2013. Retrieved from http://www.ibtimes.com/chinas-local-government-debt-crisis-though-heavily-leveraged-linked-shadow-banks-provincial-1442176 accessed on 29.10.13

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the shadow banking system are enhanced, because it is the place of competition, which can

pose problems as it has lessened governance.30

The shadow banking system also engages in Over the Counter (OTC) securitizations and

mortgage backed products that may give rise to a bubble in China, which means that there

has to be appropriate governance to protect the markets from unsustainable acts.31

Consequently, there needs to be a system of law and governance that can promote the

competition of China’s shadow banking system to counter the failures of the mainstream

banking system32, whilst reducing the risk that is inherently present.33 However, the

regulatory model needs to be flexible enough to support sustainable public projects that will

grow the infrastructure or innovative securitizations that make China an economy of choice

for investors.34 The potential benefits of the Shadow Banking system are clear, but

unsustainable and inherently risky decisions may create a shock or bubble, which will

undermine the system in a manner that is similar to the failures in the EU and the USA.

Therefore, different responses to shadow banking governance will be compared in the post-

GFC era in the EU and US, which will then be applied China.

2.4 Corporate Governance, Large Scale Banking and Shadow Banking in China:

2.4.1 The Mainstream Banking System:

The PRC’s mainstream banking system is shielded from the many fluctuations, because it is

heavily regulated by the government. The problem with this system is that a rigid system is in

place. This rigidity means that it does not have the flexibility to work within the international

markets, but it has a stability that banks internationally did not have in respect to the shocks

of the GFC.35 The mainstream banking system is heavily secretive. As Morrison reports:

“The Chinese government generally does not release detailed information on the

holdings of its financial entities, although some of its banks have reported on their

level of exposure to subprime U.S. mortgages”.36

The implication is that there is a lack of transparency in the mainstream banking framework,

which undermines the liberalisation project. There may not be risk, which is a fundamental

30 Shen (n2), 2331 Shen, (n23), 8332 S. Song “China’s economy: Five biggest banks tripled bad debt write-offs in first half” International Business Times, OCT 23, 2013. Retrieved from http://www.ibtimes.com/chinas-economy-five-biggest-banks-tripled-bad-debt-write-offs-first-half-143777433 Wei & Davis (n22).34 R. Schmitz “will China bring its Shadow Banks out of the shadow?” Market Place, JUN 26, 2013. Retrieved from http://www.marketplace.org/topics/world/will-china-bring-its-shadow-banks-out-shadows 35 Morrison, WM “China and the Global Financial Crisis: Implications for the United States” (2009) Congressional Research Service Report 7-5700, June 3rd 2009, 536 Ibid, 5

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concern in the post-GFC era,37 but there is not the necessary mobility needed to create an

effective international market.38This means that the shadow banking system is necessary in

the PRC to create fluidity with the markets, especially with Taiwan and Hong Kong who can

be regarded as the access for PRC companies to the West.39

Arguably, the nature of risk is different in the Chinese banking system than the liberal models

of the West. The main concern in the EU and the USA is to reduce the risk posed by shadow

banking, because the framework has allowed unhealthy acts to undermine the whole of the

financial system.40

2.4.2 The Shadow Banking System and Diversity:

The benefit of the Chinese shadow banking system lies with the framework that is centred

upon creating diversity and competition where there is a rigid and secretive system. This

makes it difficult to determine the validity of the reports of the success of these banks. 41 In

addition, the effect of the GFC and the risks that were seen in the West has made lending

from the main Chinese Banks even more difficult.42 This means that riskier projects,

especially with regards to local government projects will turn to the deregulated shadow

banking model. The rules for official Chinese banks require “lenders to hold more than one

fifth of their deposits in reserve at the central bank. For instance, ICBC, the world’s largest

bank by market value, reported a first quarter (of 2011) net profit of Reminbi 53.8 billion, up

29 per cent from the same period one year earlier”.43 The holding of these funds will mean

that the banks are less likely to engage with risky activities, because the central reserve can

claim them to bail the bank out (or the economy).

This has to be juxtaposed with China’s shadow banking, which in contrast is a lot less

regulated. Certain activities, such as securities are monitored by the China Banking

Regulatory Commission, State Council, and Central Bank. These parties’ role in regulating

the shadow banking system has arisen due to the growth and perceived threat this system

37 Cannata, F and Quagliariello, M The Role of Basel II in the Subprime financial Crisis: Guilty or not Guilty (2009) Carefin Working Paper 3/09, 438 Shen (n2), 2339 Meng, F “Gatekeepers: bonding benefits of listing Chinese Companies in Hong Kong” European Business Organization Law Review Vol 14, Iss 2, 265-303. 2013., 26740 Pol, E” Understanding the global financial crisis” (2009)9th Global Conference on Business & Economics Cambridge University, 5l Keys, BJ, Mukherjee, T, Seru, A and Vig, V “Did Securitisation Lead to Lax Screening? Evidence from Subprime Loans” (2010) The Quarterly Journal of Economics 125(1), 34141 Rabinovitch, S "Doubts Cast on Stress Tests’ All-clear for Chinese Banks," Financial Times, November 22, 2012, p.4.42 Anderlini, J "Strong Profits at China Lenders Despite Tightening", Financial Times, April 29, 2011, p.16.43 Shen (n23), 81-2

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highlights.44 The inference is that the current system is creating and breeding risk, which

means that greater regulation is needed. However, the nature of the regulation should not

make a stranglehold on the banking model.45 Thus, Xiao Gang, a director on the board of the

Bank of China, reports that:

“Shadow banking can broadly be described as the system of credit intermediation

involving entities and activities outside the regular banking system”.46

The consequence of this is that the banking system is deemed to be a systemic risk, which

needs to have greater regulation. In fact, Xiao Gang reports that there is a strong likelihood

that the Chinese shadow banking system can being about another subprime crisis.47 This may

be true; however the regular banking system has its own problems. These primarily focus on

the rigidity of the system that is closed, which ironically created the shadow banking

system.48 Thus, the development of the legal framework has to consider a different approach

to govern the shadow banking model.

2.4.3 Systemic Risk and Creating a Sustainable Framework:

A systemic problem that is arising is that regulations and controls are not being developed

upon a sustainable framework.49 The question is how to create a balance between

diversification and governance. The Renmibi focus creates a systemic problem for the

mainstream banking system, because it creates rigidity, which is a problem that has been

highlighted in the application of capital maintenance under the Basel Regime.50 The main

difference between the Chinese and Western banking systems is in the former there are

stringent rules and monitoring.51 Therefore, a stringent regulatory or monitoring system over

the shadow banking system will not help; rather there needs to be a flexible-principles based

system. Thus, a principles, risk aversion framework of legitimate minimums will be a more

appropriate approach.52

44 Hsu, S, Li, J & Qin, Y “Shadow Banking and Systemic Risk in Europe and China” Cityperc Working Paper Series no. 2013/02, 1745 Ibid, 17; 46 Xiao Gang, Regulating Shadow Banking, China Daily (Oct. 12, 2012)47 ibid48 Editor, “Taming of China Shadow Banks crimped by archaic regulatory structure” Euromoney July 2013 retrieved from: http://www.euromoney.com/Article/3228047/Taming-of-China-shadow-banks-crimped-by-archaic-regulatory-structure.html accessed December 3, 2013. 49 Taube, M “China’s Shadow Banking Sector – Pillar or Threat to the System” in Nowotny, E, Mooslechner, P and Ritzberger-Grunwald, D European Integration in a Global Economy: CCSEE and the Impact of China and Russia (Edward Elgar, 2012), 19350 Demirgüç-Kunt, Asli, Edward Kane, and Luc Laeven (eds.) Deposit insurance around the world: issues of design and implementation (MIT Press, 2008), 1051 Shen (23), 8352 Dowd (n17), 145

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The best framework for developing these minimums are already in place within the PRC’s

legal system, which is its implementation of the Organization for Economic Cooperation and

Development’s (OECD’s) Best Practice Principles (BPP). These principles are modelled on

the voluntary corporate governance from the UK, which means that they are highly flexible.53

The banking system’s corporate governance framework has also implemented the OECD’s

and Bank for International Settlements’ (BIS) principles of Enhancing Corporate Governance

for Banking Organizations in 1999.54 This framework, once again, is based upon creating a

sustainable approach to corporate governance. This can be identified in the foundational

principles, which are: 1) transparency; 2) integrity; 3) uniformity; and 4) international

confidence in the global financial crisis.55

The implementation of this framework stems from the failure of the banking system in the

Asian Financial Crisis; whereby implementing these principles will develop investor

confidence within the PRC’s banking system.56 The aim after the Asian financial crisis was

both diversification with substantive supervision. As the Basel Committee on Banking

Supervision identifies in the post-GFC era:

“The need for strengthening supervision of banks has particularly been stressed as a

major priority since it is now widely recognised that weaknesses in banking systems

have been at the core of financial crises in many countries over the last decade. As

current banking crises affect many countries, both developed and emerging… In order

to minimise the risk of contagion, developed and emerging countries are being

strongly urged to adopt and effectively implement sound supervisory methods”.57

The development of a supervisory framework in PRC is problematic, because its national

banking system is too concentrated in power58 with a stringent regulator that has forced the

growth of the shadow banking framework. The implication is that the lack of competition is a

specific concern in the mainstream system.59 This means to subject the shadow banking

system to the same level and type and regulation of the mainstream banking system then a 53 Fan, J, Morck, R and Yeung, B “Introduction” in Fan, J, Morck, R and Yeung, B (2011) Capitalising China (University of Chicago Press, 2011), 854 BCBS (1999) “Core Principles Methodology” October 1999 BIS; BCBS (2009), International Framework for Liquidity Risk Measurement, Standards and Monitoring, Consultative Document; Basel Committee on Banking Supervision; BCBS (2010), Annex55 Ibid, 356 Ibid, 357 Ibid, pg. 358 Globerman, S, Peng, MW and Shapiro, DM (2011) “Corporate Governance and Asian Companies” Asia Pac J Manag 28(1); Yin-hua Yeh, and Tsun-siou Lee. (2001): "Family Control and Corporate Governance: Evidence from Taiwan" International Review of Finance 2(18), 2559 Shen, W “China’s Central Bank in the Post Financial Crisis Era – Understanding and Rationalising its Monetary Policies and Challenges” (2013) Journal of International Banking Law and Regulation 300, 303

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different form of risk arises (i.e. the lack of competition, which will undermine

liberalisation). Thus, this discussion will consider which forms of governance and legislative

options will be most appropriate to remove risk from China’s shadow banking system.

3.0 Governance and Legislative Options to Remove Risk in China’s Shadow Banking

System – A Comparative Case Study:

3.1 Some Regulatory Options:

This chapter will examine the potential governance and legislative options that can be used to

fight any risk, in order to do this it will draw upon the post-GFC techniques that have been

used in the USA and the EU. In the EU and the USA there has been a number of approaches

to limit the risk of the shadow banking system, which include the Basel III, Regulation (EC)

No. 1060/2009 on credit rating agencies (Credit Rating Agencies Regulation) and the

Directive on Alternative Investment Fund Managers 2011/61/EU. The implementation of a

regulatory framework in the EU illustrates the need to bring uniformity across the EU to non-

standard (and standard) banking systems.60 The USA has implemented regulation that bears

core principles in risk, which includes the development of the Volcker (i.e. ring-fencing

rule).61 The basis of these models is to monitor securitization and mortgage-backed products,

which are prevalent in the shadow banking model (e.g. OTC products).62 The implementation

of the Basel III requirements that focus on flexible and substantive supervision are hoped to

regulate the shadow banking system whilst retaining the necessary flexibility to retain these

markets.63 Tang identifies that the PRC regulatory model is considering the ring fencing

model, albeit continually putting this framework on hold.64 The ring fencing model, which is

based upon separating risky products from OTC products, may not work in China, because of

the historic concentration of power.65 Thus, it is not advised that the ring-fencing model is

applied, because it will only increase the risk association with lack of competition in the

mainstream banking system.66

The EU’s regulatory model will also not work in China’s regulatory model, because the

system is overly rigid.67 However, the implementation of the principle-enhanced Basel III

60 Box, T Cummings, R, Oddy, L Abbott, SJ, Balkwill, I and Tanney, T Berwin Leighton, Paisner LLP, (2011) “Cross-border Securitisation” PLC practical law company online, available at: http://crossborder.practicallaw.com/1-501-1955#a649269 accessed 3rd December 2013, 61 Ibid,.62 ibid63 Tang, Q “The US financial regulatory reform, causes of financial crisis and its enlightenment on China” (2011) Frontiers of Law in China 6(4),. 533-464 Ibid 53465 Ibid, 53566 Shen (n62), 30467 Ibid, 303-4

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framework will have an effective role.68 The focus in a simplified system that is based on

transparent structures and a high degrees of responsible banking will be more effective than

regulation and/or ring fencing.69 There is a definite need to create a framework that enables a

flexible securitization model, but ensures that there are principles in the system to prevent

systemic risk.70 Shin argues that the best approach is to develop a set of principles that do not

allow the distortion of incentives and the misuse of OTC products.71 OTC products create

innovation in the financial markets, which leads to a competitive framework. This is the

reason why the shadow banking system has been particularly successful in China.72 The main

risk that is present in the shadow banking system of China is that there is not sufficient

substantive supervision. Thus, the final part of this chapter is going to examine how the

Chinese Shadow Banking system can be empowered.

3.2 A Proactive Model of Governance in the Shadow Banking Framework:

This part of the discussion will explore the findings from the previous chapters to answer the

first four sub-questions. Deductive reasoning will be used in the OTC case study of

securitization and mortgage backed products in China’s, the USA’s, and EU’s Shadow and

mainstream banking systems.

The main factors that have been identified so far is that there cannot be a strict regulatory

model, because the shadow banking system will be engulfed into the mainstream banking

framework. This will create an anti-competitive risk that will give rise to stagnation of the

Chinese financial markets.73 The use of this model will also rely fallaciously on risk

reduction, which the GFC illustrates cannot be formalistic in nature.74 This is further

supported by the failure to adequately regulate the shadow banking system in the USA and

EU markets. As Dam indicates the formalistic standards were not able to deal with OTC

securitization of shadow banking.75 This is because shadow banking does not work through

the normal banking channels; rather the use of the less regulated broker-dealers, hedge funds

and private equity firms create a flexible system that can be misused.76

68 van der Eijk, R and Steenwinckel, J PwC (PricewaterhouseCoopers), (2011) “Capital management in banking: The Way Forward” The European Financial Review, available at: http://www.europeanfinancialreview.com/?p=4296 accessed December 3, 201269 ibid70 Shin, HS (2009) “Securitisation and Financial Stability” (2009) The Economic Journal 119(536), 31071 Ibid, 31072 Shen (n2), 2173 Shen (n62), 30474 Dam, KW ”The Subprime Crisis and Financial Regulation: International and Comparative Perspectives” (2010 ) Chicago John M Olin Law & Economics Working Paper No. 517 (2D Series), 2575 Ibid, 2576 Ibid, 25

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The flexibility of the shadow banking system can be beneficial, as long as substantively

supervised.77 The use of ring fencing has been called into question, because it has had

negative effects on the USA’s mainstream and shadow banking markets.78 Rather, the level of

governance needs to differ in the banking system (i.e. mainstream banking needs to be

heavily regulated; whereas the shadow banking system needs to be dealt with in a flexible

manner).79 This does not mean that there should be no regulation; instead, there should be

appropriate regulation to meet the needs of the particular banking and financial markets.

In the case of China’s shadow banking system, there should not be a model that is distorting

the competitiveness and diversity, which are present. Smart regulation needs to be applied to

target the specific areas of risk that may arise. This smart regulation can be developed to

target the unsustainable concentration of power in the mainstream system. The way that this

flexibility can be created is through limiting moral hazard, which means that principles have

to be enhanced in the system. Thus, a formulaic approach, such as ring-fencing should

avoided. The core problem with ring fencing is that it will promote an enhanced anti-

competitive atmosphere.80 Rather, a model of supervision needs to be developed that will

trace the funds and prevent the abuse of the system to create risk through distortion.81 As Shin

identifies:

“There are two pieces of received wisdom concerning securitisation – one old and one

new. The old view (prevalent before the outbreak of the credit crisis 2007/8)

emphasised the positive role played by securitisation in dispersing credit risk, thereby

enhancing the resilience of the financial system to defaults by borrowers… [T]here is

a new wisdom which emphasises the distorted incentives that developed at all stages

of the securitisation process, which allowed the ‘hot potato’ of bad loans to pass

through the financial system to be held finally in the hands of unsuspecting final

investors”.82

These two pieces of wisdom are present conjointly in China, which is that credit risk can be

dispersed. The framework also ensures that there is competition. Nevertheless, when misused

it can distort the system and enhance risk. 77 Hutton, HJ “Unintended Consequences: The Volcker Rule and Securitization” (2012) Practical International Corporate Finance Studies 38(7), 278 Ibid, 279 Mills, A Essential Strategies for Financial Services Compliance, (John Wiley & Sons , 2008), 1680 Tang (n66), 53581 Lacobucci, EM and. Winter RA “Asset Securtisation and Asymmetric Information” (2005) Journal of Legal Studies 34(162), 16582 Shin (n73), 309

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Distortion can be avoided by creating a vested interest for the shadow banking organisations,

which engages with its investors through a principles-based relationship model.83 The focus

of this model should be the development of substantive principles and supervision, which can

counter risk whilst not stifling competitiveness. The development of a fiduciary model with

an obligation of due diligence may be a way to limit risk.84 The development of a trust model

has been developed in some jurisdictions to deal with this fundamental problem.

Shares are of such a nature that the development of a trust model can be a way to impute a

fiduciary framework, as well as enabling equalisation of risk for the investor.85 The duty set

in Pitt v Holt86 can provide the basis for proper administration of the securitization trust. A

breach will occur when there is sufficient gravity of mismanagement, which means a

substantive model of principles, supervision and liability can be created. The concerns of

maintaining flexibility can also be upheld, because the fiduciary model is not set in stone.

Rather, the obligations will adapt to the given facts and circumstances. Therefore, the

obligations of shadow banking should be developed upon a fiduciary model, which can give

rise to a trust based model when necessary. The development of the trust model will be

particularly beneficial, because it enables a framework that is tackling the ethos of risk. The

flexibility of shadow banking system is essential to developing a competitive financial

markets framework. The GFC highlights that OTC securitization can create risk, but it is

clear that it creates opportunity too. It is the opportunity that is necessary in China, due to the

rigidity of the mainstream banking system. Hence, developing a fiduciary duty will ensure

that there are obligations in place that should encourage the minimisation of risk.

Inferentially, the benefit of the proposed model is that it can develop principle-based

supervision whilst maintaining the flexibility and diversity of China’s shadow banking

system. It is also important that the mainstream banking system undergoes reform, in order to

converge with the flexibility of the shadow banking system (however, this will be a long-time

in the making).

4.0 Conclusion:

The Conclusion will now synthesise the case study data and make a number of

recommendations on the form that good governance should take, in order to fight the

potentially unsustainable risk posed by China’s shadow banking system. It has been 83 Ibid, 16584 Smith, P, Cox, B and Edmonds-Wilson, I (Mallesons Stephen Jaques,) (2011) “Australia Securitisation” PLC practical law company online, available at: http://www.practicallaw.com/crossborderhandbook5-500-0016 accessed December 3, 201385 Re Harvard Securities [1997] 2 BCLC 369 86 Pit v Holt [2011] EWCA Civ 197

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identified that China’s shadow banking system is necessary to the overall framework of

competitiveness and access to banking products. Thus, the system cannot be removed or

heavily regulated; otherwise it will be subsumed into the main banking system’s rigidity. The

application of ring-fencing will create the same problem. Inferentially, the approach needs to

be based upon a flexible model of principles.

These principles are present in the banking system through the BCBS Principles, which are

based upon a voluntary corporate governance model. Nevertheless, this framework will not

be sufficient without a substantive liability matrix. This matrix cannot stem from the

formulistic model of law applied in the PRC’s civil law system. Thus, it is recommended that

a common law trust model is used. This framework is present in Hong Kong, which means

that a culturally compatible trust system can be developed. The use of a trust will create a

direct relationship between the shadow banking organisation and the investor investing in

OTC securities. The overall implication of this is that the negative risk associated with

securitization can be countered without undermining the innovation and flexibility. In

conclusion, China’s shadow banking system may pose a risk to the stability of the financial

markets. Nevertheless, there is an enhanced risk if the shadow banking system was removed.

On this basis, it is necessary to develop a system of regulation that is principles-based and not

entrenched in rigidity. Rigidity would create an anti-competitive risk due the concentration of

the market. Therefore, the use of a flexible trust/fiduciary model may be able to balance the

conjoined risks present in the Chinese banking system. The exact route to develop this

framework is not clear, but PRC could borrow from Hong Kong’s trust model to ensure that

flexibility and diversity remain in the financial markets whilst the risk of shadow banking

distortion through abuse of securitization is minimised. This framework indicates that there

are some lessons for the mainstream banking system to consider, but to understand this

interaction further study is necessary.

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Case:

Pit v Holt [2011] EWCA Civ 197

Re Harvard Securities [1997] 2 BCLC 369

Web-sites:

http://ec.europa.eu/ http://economicsofcrisis.typepad.com/

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http://papers.ssrn.com http://papers.ssrn.com http://westlawchina.com http://www.boc.cn/en/index.html http://www.hkma.gov.hk http://www.lexisnexis.com https://www.lawtel.com www.rmb-business.com/en www.westlaw.co.uk

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