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WHAT CHINA CAN LEARN FROM THE DEVELOPMENT OF INVESTMENT BANKS IN MATURE INTERNATIONAL MARKETS

Previous sections analyzed what China can learn from various aspects of investment banks in mature international markets. This section is an overall analysis of how the evolution of international investment banks (especially after the outbreak of the subprime mortgage crisis) may inform the future development of Chinese securities companies.

Messages in Terms of Regulation

The subprime mortgage crisis exposed the flaws of the U.S. securities market in terms of regulation. For example, the overreliance on self-regulation of the market and the deregulation effort weakened the strength of regulators. The net capital and leverage rate requirements were not strictly followed. Information disclosure in the OTC market was extremely opaque, and supervision of credit rating agencies was weak. These regulatory shortcomings, exposed in the U.S. subprime mortgage crisis, are very helpful references for regulation in the Chinese securities market.

Strengthening Regulation on Derivatives

There are many types of credit derivative products traded by a variety of market players. They are indispensable financial tools for investors to manage credit crises. They have such important functions as spreading out credit risks, raising return on capital, and improving basic asset liquidity and financial market efficiency. Credit derivative products represent a new round of consolidation in the financial market that has brought financial institutions to more market areas. By connecting all markets, they have improved the liquidity of the markets and improved their efficiency.

The financial vulnerability exposed by the subprime mortgage crisis didn't come from financial innovation itself, but from the insufficiency of regulation. Regulatory policies in the past gave free reign to financial institutions, which led to the failure of the regulatory system. Lacking regulation on financial innovation was the fundamental reason behind the financial crisis and economic recession. Of course, regulation should not stand in the way of financial innovation. Giving more choices to financial consumers and extending the availability of credit makes financial innovation indispensable. Financial innovation is also essential for the realization of flexibility in the financial system without hindering the attainment of the goals of the market process. Regulators should focus on the overall interests of society, rather than the interests of individuals. Regulation should be conducted with greater foresight, focusing on the prevention of systematic risks.

The subprime mortgage crisis showed that it is extremely important to strengthen comprehensive and prudent regulation and risk control on financial derivatives. For that purpose, regulators should specify the upper limit for leverage applicable to product and business innovation in securities companies and enhance sensitivity analysis regarding the effect of market changes to innovative business. This helps nip potential crises in the bud and make risk regulation systems and mechanisms keep pace with financial innovation.

Securities companies should strengthen risk management and control over product and business innovation, using financial leverage prudently to maintain the leverage rate at a proper level, thus lowering control and operation risks. Securities companies should also include product and business innovation risks into the overall comprehensive risk-management system of the company, clearly defining the specific responsibilities of various business lines and relevant divisions. The internal control system and mechanisms should be improved so that the nature, variety, and scope of financial innovation (especially off-balance-sheet business positions) are commensurate with the net capital scale and the risk management and control system, as well as the risk management and internal control capability of the company. Irregular inspections on off-balance-sheet business should be strengthened for early detection of potential risks in off-balance-sheet business operation. Securities companies should provide a greater amount of useful information concerning the structures and subject matters of complex financial derivatives to improve the transparency and effectiveness of financial regulation.

 
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