(Yicai Global) May 21 -- Financial supervision cannot give way to the moral hazards of financial institutions, and the basic framework of financial supervision based on separate operation should remain, said Sun Guofeng, director of the Financial Research Institute of central bank, the People's Bank of China (PBOC), at the 2018 Tsinghua PBCSF Global Finance Forum on May 19.

Organized by Tsinghua University PBC School of Finance (PBCSF), the Forum focuses on new thinking, trends, practices, and dynamics of China's financial reforms, and seeks to address pressing issues.

Efforts should be made to standardize comprehensive financial management and strengthen comprehensive supervision and control, so as to effectively guard against financial risks and fight a battle against financial risks and major risks, he added.

The separate operation is fundamental to financial support for the real economy and prevention of risks, he said. Since companies in the real economy focus on their main business, while consumer demand is unlimited, such firms are not likely to provide all products to consumers. In this sense, financial institutions must also focus on their main business. It is natural for them to have a desire for mixed operations to pursue their own interests. However, from a historical point of view, the regulatory concessions made in compliance with the demands of financial institutions for mixed operations are often the major source of financial crisis.

In fact, Sun said, many Chinese financial institutions and some non-financial companies themselves have run some mixed operations over the past decade. While increasing the diversity and competitiveness of financial institutions, mixed operations have also magnified moral hazards and conflicts of interest. It challenged the risk management and financial supervision of financial institutions, and also brought about risks across industries, markets and regions.

Firstly, it resulted in the cross-border expansion of financial institutions. Some financial institutions pursued multi-licensing and full-licensing, and some enterprises controlled different types of financial institutions and became barbaric financial holding groups. This led to problems such as capital flight, circular capital injections, false capital injections, and transfer of benefits through improperly connected transactions. Secondly, operational cross-border arbitrage was generated as a result. Shadow banking is one example, and cross-investment, leverage amplification, interbank arbitrage, and a shift from real economy to the virtual economy are the problems.

Historically, there are several risks in mixed operation. First, the risk of non-transparency. Because of the complexity of mixed operation, the risk of a financial holding group is not simply equal to the sum of the risks of each entity within the group. Therefore, investors and regulatory authorities may find it difficult to accurately understand the structure and risk situation, and they cannot see the risks clearly. Regulatory responsibilities are also unclear.

Secondly, moral hazards may appear given that banks can obtain support from deposit insurance and the lender of last resort. On one hand, a financial holding group backed by such guarantees may be too big to fail. On the other hand, non-bank financial institutions under the group may indirectly take advantage of the government's implicit guarantee offered to banks at the prospect that the group and banks under the group will come to their rescue in times of crises. Such expectation may invoke risk-taking behaviors of the financial holding group and non-bank financial institutions under the group. 

Another risk is regulatory arbitrage. Different financial services have different risks that result in different supervision requirements, especially requirements on capital. Financial holding groups may engage in arbitrage by taking advantage of such supervision differences. For instance, double or multiple liabilities refers to the use of the same capital by two or more entities under a financial holding group. Another example is excessive leverage, which means that after obtaining funds through debt issuance, a financial holding company may inject the funds in its internal banks and non-bank financial institutions in the form of shares.

Finally, mixed operation is unfavorable to the protection of investors. Theoretically, a financial holding group should pursue a physically synergistic effect to lower cost. In reality, however, instead of being content with the physically synergistic effect among its subsidiaries engaging in different business, a financial holding group may feel a strong impulse to carry out regulatory arbitrage through overlapping business operations, which increases relevant risks because of the large-scale and high complexity of its business.

Editor: William Clegg