a. Introduction:

The existing legal and regulatory barriers between banking, securities and insurance activities are primarily represented by Art 43 of the 1995 Commercial Banking Law, Art 6 of the 2006 Securities Law and Art 6 of the 1995 Insurance Law. These legal rules have established the general principle of business separation that prohibits cross-sector operations. Of course this principle of separation of business is also supported by other legislation, apart from other legal rules in the mentioned three major legislation on banking, securities and insurance. For example, Art 20(4) of the 1996 PBOC’s General Principles of Loans provides that bank loans may not be used on trading stares and futures.

Under this strict principle of separation of business  which require banking, securities and insurance services be offered by separate financial operational institutions and which prohibits cross-sector operations, using financial holding company to achieve some of the benefits of financial conglomerates has been the only feasible option left in China. 

Thus far there are four major types of financial groups in China. The first type is the financial groups that are formed by non-banking financial institutions, with interests in banking, securities and insurance, as well as in trust and investment companies. Two prominent examples are the CITIC group and the Pinan Group. The second type of financial groups is the financial holding companies which are solely or jointly established by the state-owned commercial banks in overseas jurisdictions. In addition, such state-owned commercial banks also can use this approach to establish subsidiaries other than holding company to directly engage in securities or insurance business.The Third type is the financial holding companies formed by industrial sectors (enterprises other than financial institutions), as such enterprises are not prohibited by law to invest in financial institutions.

b. Existing primary legal barriers:

Despite the strong and growing presence of financial groups by using the model of financial holding company as well as major state-owned banks’ expanding into insurance business and securities business through establish overseas subsidiaries, it should be noted that, as discussed above, banking, securities, and insurance services still shall be offered by separate financial operational institutions as separate legal entities (other than financial holding companies), under the principle of business separation. Thus this primary legal barrier remains there.

Moreover, despite the presence of the aforementioned second type of financial group, Chinese commercial banks are still generally prohibited by Art 43 of the Commercial Banking Law to invest in non-banking enterprises. Even though some Chinese commercial banks were allowed to expand into insurance and securities business and to form financial conglomerates through establishing overseas subsidiaries, they are still very isolated cases, being limited to a few major state-owned commercial banks thus far. Not to mention in terms of Chinese mainland securities and insurance market, such overseas (mainly HK) subsidiaries probably would be confronted with much more extra regulations than their domestically incorporated competitors. As for some cases in which commercial banks are approved to establish subsidiaries in the territory of China to engage in securities or insurance business, as in the case of Bank of Communications’s joint venture fund management company, they are basically exceptions resulting from the government’s special approval. All in all, this legal barrier for Chinese commercial banks to investments in non-banking institutions and enterprises is very significant, considering that the sector of commercial banks probably handles the largest amount of money in this country with the largest savings in the world. Similarly, Art 104 of the Insurance law also prohibits insurance companies from using their funds to set up organizations conducting securities business or to invest in enterprises.

c. Should the existing legal barriers be removed?

  I. Potential benefits of removing the existing barriers between banking, securities and insurance activities:

    1. Alleviating commercial banks’ pressure to compete with investment banks and leveling the playing ground (inapplicable in China):

When considering whether to remove the existing barriers that reflect the principle of business separation, it is beneficial to look to what prompted the USA to repeal the principle of business separation and the Glass-Steagall Act. It is widely believe that the major incentive for the commercial banks in the USA to lobby for repealing this Act is that repealing the Act can bring them much more earnings from fee-based securities services to make up for losses from their fierce competition with investment banks in terms of financing method (loan financing versus capital market financing) and client base. They argued that they came under enormous pressure as enterprises in need of money increasingly turn to capital market. They further argued that they had to compete fiercely for funds, as depositors instead of saving money in banks increasingly chose to invest their savings in, for example, money market and mutual funds[1]. Sound as such arguments are in the USA, they are not effective ones in China, as the Chinese have the tradition to save, rather than excessively consuming. Thus, Chinese commercial banks have sufficient funds. Moreover, despite the rapid development of the Chinese capital markets, borrowing from commercial banks remains the main channel of financing for most Chinese enterprises, especially for medium-to-small sized enterprises which contribute the largest share of the Chinese GDP but find it very difficult to have access to capital market in current China. Therefore, Chinese commercial banks’ earnings are not perceived to be undermined by the securities sector’s development.  In fact, Chinese commercial banks are overall very strong in terms of financial strength and fare well in their core business area of taking deposits and extending credits. Thus, there is no perceivable pressure to compete with investment banks currently.

    2. Maintaining financial stability by absorbing losses within financial conglomerates. (Not effective where the losses are enormous and epidemic enough)

Some argues that the financial stability can be better served if removing the existing legal barriers among various financial sectors, on the ground that within a financial conglomerate, for example, the losses from the insurance and securities subsidiaries can be offset by the bank subsidiary’s earnings. But the author believes that such argument would not be effective where such losses are huge and epidemic enough. If that situation happens, as in the case of the recent financial crisis in the USA that was triggered by the subprime-mortgages crisis, the financial stability would only be broken.

     3. Reducing transaction costs

First, removing the existing legal barriers between various financial sectors can create one-stop financial services supermarkets, as customers can bargain only with one contractual party, as opposed to there.

Second, information of banks’ clients that is collected in the process of extending credits to them is valuable asset. Thus, removing the existing legal barriers would allow affiliated securities or insurance companies to make full use of such information to better conduct their businesses. 

Third, banks can provide their securities or insurance affiliates with a more developed and wide distribution networks that represent more established customer relationships for the sale of the securities or insurance products of banks’ securities or insurance affiliates.

II. Potential cost of removing the existing legal barriers:

  1. Conflicts of interest:

Removing the existing legal and regulatory barriers among various financial sectors would create conflicts of interest that prevent commercial banks from acting either as impartial lenders or as objective investment advisors[2].

Due to the inherent conflicts of interest within financial conglomerates, the bank may make risky loans or capital contributions to a securities or insurance affiliate, especially as the bank is closely associated in public mind with its affiliates. If the latter sustain huge losses it is unthinkable that they would be allowed to fail[3]. It follows that transfer of loss within a financial conglomerate would result. If such losses are huge and epidemic across the whole financial sector, systemic financial risks would arise.

The bank may also make risky loans to a securities affiliate’s customers in order to facilitate the affiliate’s distribution of securities[4], as in the case of risky subprime mortgages loans and their securitizations in the USA in recent years.

Another scenario is that a bank of a financial conglomerate may have extended a loan to a non-financial company that has since turned bad. In order to recoup the loan, the financial conglomerate may have its affiliated securities company to underwrite an equity issue of the struggling non-financial company and convey misleading financial information to capital market investors about the non-financial company’s performance. Having done so, the financial conglomerate can use the proceeds of the equity issue to have its NPL repaid. Alternatively, if investors don’t buy the misleading representations as to the equity issue and don’t buy in the securities, the financial conglomerate could sell the unsold securities to its trust investment company, ultimately hurting the interests of the trust investors[5].

  2. Lack of innovation:

Some scholars argue that financial conglomerates are engaged in a zero-sum game in terms of the development of innovative capital market instrument, as any new mandate won by the investment banking affiliate may take away business from the commercial banking affiliate[6]. They further argue that under such circumstances, financial conglomerates may have few incentives to invest in research and develop new financial products. The author agree with them on this, considering that even the financial conglomerates are confronted with the completion with standalone investment financial institutions which keep the incentives to develop new financial products, financial conglomerate still would be reluctant to do so as newly developed financial products can be quick to be understood and adopted upon their introductions to the market.

Some scholars maintain that financial conglomerates in the long run would crowd out other financial institutions due to their superior scale as well as the fact that in practice commercial banking affiliates can subsidize the securities or insurance affiliates by extending to the latter credits at preferential interest rates that are below the market interest rates. They further argue that this would cause another drawback of financial conglomerates, namely, crowding out other standalone financial institutions and concentration of financial power in a relatively small number of huge financial conglomerates. But the author opines that even though that kind of concentration happens, it does not by itself represent a bad thing. Some may argue that this drawback of crowding-out effect is reduction of competition,but the competition among the financial conglomerate still remains. However, it is prima facie true that more financial conglomerate and less standalone financial institutions would lead to less innovation of financial products.

  3. Contributing to financial instability or even financial crisis (and ultimately economic crisis):

The CBRC chairman, Liu Mingkang recently addressed at 2008 Caijing magazine Annual Meeting and he associated the current US financial crisis to the repeal of the Glass-Steagall Act, arguing that China should maintain the status quo of the existing legal barriers between various financial sectors.

     (1) From the perspective of underwriting and trading risky instruments which are widely believe to be at the heart of this current financial crisis:

Indeed, it is true that the repeal enabled commercial banks such as Citigroup to underwrite and trade complex and opaque instruments, such as mortgage-backed securities (MBSs) and CDOs through their securities affiliates.

Moreover, the bank of a financial conglomerate and its securities affiliate would be tempted to take greater risks because of their assumption that the bank could remove sour loans from its balance sheet by transferring them to its securities affiliate and then by having the latter pool and securitize the sour loans with other loans into such products as MBSs and CDOs[7]. And such securitized sour or subprime loans, as in the case of subprime mortgage loans in the US financial crisis, can be ultimately sold to general investors. Thus, the whole process creates a sort of moral hazard, prompting financial conglomerates to make more risky mortgage loans without due care about the potential risks involved in such products, since they assume those sour assets would ultimately be transferred to general investors anyway and removed from their balance sheets.

Some may argue that the process of securitization is one of diversifying risks by pooling, for example, relatively bad mortgages and relatively sound mortgages, with an individual investor only having exposure a fraction of the total value of the pool of underlying assets.

But this author opines that where losses are huge and epidemic enough, as in the case of subprime mortgage crisis happening in recent years in which the burst of US real estate bubble led to epidemic and huge losses from mortgage-backed securities and CDOs, the sense of security arising from the said assumption is simply false. This is simply because even the largest financial conglomerates were not strong enough to absorb the losses and remain afloat. Under such circumstances, where major financial conglomerates across the whole financial sector suffer huge and epidemic losses from those mentioned financial instruments characterized by securitization, as in the case of the US major financial conglomerates suffering losses from such products as MBSs, CDOs and CDSs(credit default swap), a systemic financial and economic crisis would result. This is because, within financial conglomerates, losses can be transferred from one affiliate to another. Securities affiliate’s losses from those risky instruments would threaten the integrity of bank affiliates’ capitals, and even lead to wide range of bankruptcies of the financial conglomerates and their affiliates. That would in turn result in credit crunch and frustrate the growth of the real economy, and thus an overall economic crisis would result, since credits extended banks are bloods of the real economy. And accordingly, insurance affiliates’ losses from CDS products, for example, would also adversely affect the real economy’s needs for insurance, as in the case of AIG in the US. All in all, financial conglomerates’ underwriting and trading risky financial instruments (any instruments is of some extent of speculative nature and therefore they are risky) would contribute to financial and economic crisis if the whole financial market slumps and they suffer epidemic and massive losses.

     (2) From the perspective of macro-economy:

Removing the existing legal barriers and allowing the enormous amount of funds from commercial banks and insurance companies into the capital market would naturally contribute to an explosion of debt and equity finance, making for a boom and bust cycle. Such an explosion would in turn make for over-investment, inflation and asset bubbles, including those of real estate markets and of stock markets. Such asset bubbles are simply the symptoms signifying that the virtual economy represented by the financial sector is too much off the track of the real economy. And this, according to the historical lessons, is always not sustainable. And the date of the asset bubbles would always come when some smart and sober investors choose to withdraw. After the burst of asset bubble and houses prices plunges, a massive amount of mortgage delinquencies and foreclosures would result, causing huge losses to commercial banks across the board. And this dire situation would interact with the instruments discussed above, ultimately causing a systemic risks to the financial system and the economy. In addition, a portion of financial conglomerates’ colossal amount of funds may also had been invested in the previously blooming stock market before the stock market bubble busted, thus their losses from the stock market may also greatly diminish the capitals of banks or insurance companies affiliates, causing systemic risks to the economy.

III. Conclusion: Overall analysis of benefits and costs.

On the benefits side, as discussed above, the only sound argument is concerned with reducing transaction cost by financial conglomerates through their advantages in one-stop provision of financial services, sharing information among its affiliates, and wide distribution networks of financial services. But the other two potential benefits that have been pointed out by many have been refuted by this author in this article. However, on the cost side, all the identified three major costs of removing the current legal and regulatory barriers prove to be effective and compelling.

According to the above analysis, it can be seen that all the three major costs overwhelmingly outweigh the only effective benefit of reducing transaction costs. This is because the average transaction cost saved for a specific customer of financial services, compared with a specific investor’s loss from a fraud or misrepresentations committed by a financial conglomerate because of its inherent problem of conflicts of interests, is usually trivial. Such kind of contrast of money value would only be more stunning if it is conducted between the overall benefits of reducing transaction cost and the consequence of a financial and economic crisis triggered by financial conglomerates’ underwriting and trading risky instruments. And the enormous amount of funds from commercial banks and insurance companies into the capital market shall not be seen as a good thing in the long run, as that would only contribute to an explosion of debt and equity finance and make for a boom and bust cycle. This explosion of finance may only complicate the government’s monetary policy to adjust the money supply to control inflation and prevent over-investments.

In conclusion, the existing legal and regulatory barriers between banking, securities, and insurance activities in China shall not be removed. Instead of expanding into other financial sectors, Chinese commercial banks, for example, shall concentrate in preventing NPLs and further improving corporate governance and capital adequacy.