Financial Services Liberalisation in the China (Shanghai) Pilot Free

Trade Zone: Reflections on Regulations and Regulators

Kim VAN DER BORGHT WANG Qian ZHANG Ji1

Abstract：With the foundation of China (Shanghai) Free Trade Zone, China’s reform

also enters a new stage. Under the era of global financial crisis, strong

and efficient financial services supervision is in urgent need. Through

analyzing the supervision situation in Shanghai FTZ, also the global

financial supervision model reform since financial crisis, financial

regulation in Shanghai free trade zone should be based on protecting the

interests of the investors and the public. Supervision should consider the

balance of cost and effect, and its target should not be too complicated.

Then the following recommendations are concluded: ○1 Financial

regulatory legislation system in Shanghai FTZ should be improved, also

macro-prudential regulation should be strengthened. ○2Offshore financial

business regulation in Shanghai FTZ should be improved; ○3 In

ShanghaiFTZ，measures should be taken to improve interest rate

marketizationsupervision; ○4 Regulation to capital account open should

be improved.

Keywords：China (Shanghai) Pilot Free Trade Zone, Financial Supervision, Policy

Suggestion

1．Introduction

The reform process of the financial sector started with the decision of the 16th

Chinese

Communist Party National Meeting in 2002, where the direction was given to start the

process and to allow privately owned business to become part of the financial sector,

this included allowing foreign-owned companies into the sector, albeit gingerly as

minority shareholders in existing (state-owned) banks.2 It has been a process of

steady but cautious reform to reposition the Chinese financial sector into a more

1 Kim Van der Borght is Visiting Professor, School for WTO Research & Education, Shanghai University of International Business & Economics; Professor of International Economic Law, Vrije Universiteit Brussel; Reader in Law, University of Westminster. WANG Qian is Associate Professor, School of WTO Research and Education Shanghai University of International Business and Economics. ZHANG Ji is Graduate, School of International Trade and Economics, Shanghai University of International Business and Economics. Corresponding author: WANG Qian (liza1234@163.com). 2 Insert reference

market-oriented logic and revise the role of the state of the regulator and the facilitator

of this process.3

The second major push in the reform process has followed about a decade later. On 17

August 2013, the establishment of the China (Shanghai) Pilot Free Trade Zone

(CSPFTZ) was approved by the State Council.4

This second push aims to

internationalise the Chinese financial sector, position Shanghai as a first tier

international financial centre and to lay the foundations for the internationalisation of

the renminbi and the eventual acceptance of the Chinese currency as a reserve

currency.

The CSPFTZ was inaugurated on 29 September 2013.5 The CSPFTZ has jurisdiction

over four customs zones: the Waigaoquiao Free Trade Zone, the Waigaoquiao

Bonded Logistics Park, Yangshan Free Trade Port Area, and the Pudong Airport Free

Trade Zone.6 The creation of the CSPFTZ has united these four customs zones that

previously operated as separate bonded areas into a single free trade zone. This

process started in 1990 when bonded areas were created and when Shanghai was also

chosen as the location to pilot this system with the inauguration of the Waigaoquiao

Free Trade Zone in 1990. This was followed in 2003 by the Waigaoquiao Bonded

Logistics Park. The first free trade port in China was the Yangshan Free Trade Port

Area (2005). In 2009 the Pudong Airport Free Trade Zone was decided and the

expansion of the zone was realised in 2012. The total area of the CSPFTZ is now 28

square km.7

The CSPFTZ is a national project that dovetails with the development plans of the

Shanghai Municipal Government. In 2006, the Eleventh Five Year Plan of Shanghai

put forward the construction of the “four centres” of Shanghai, that is making

Shanghai an international economic centre, an international financial centre, an

international trade centre and international centre.8. The CSPFTZ is part of the

implementation of this “four centres” plan.

While several cities ‘clamoured’ to be chosen for this pilot, the Shanghai Municipal

Government prevailed in its bid to host the pilot project.9 The Shanghai Municipal

Government was strongly motivated as it faced rising manufacturing costs that result

3 See Wei Ping He, Banking regulation in China: what, why, and how?, 20(4) Journal of Financial Regulation and Compliance 367 (2012). 4 Insert reference 5 WTO, Trade Policy Review China – Report by the Secretariat (WT/TPR/S/300) (27 May 2014), at 51. 6 Circular of the State Council on Printing and Distributing the Overall Plan for China (Shanghai) Pilot Free Trade Zone (GuoFa [2013] No.38) 7 Insert reference to official decisions of the state council for all these events. Also see, WTO, Trade Policy Review China – Report by the Secretariat (WT/TPR/S/300) (27 May 2014), at 51. 8 See for “Outline of the Eleventh Five-Year Plan for National Economic and Social Development in Shanghai” MORE INFO NEEDED AND REFERENCES. WHAT IS THE DIFFERENCE BETWEEN A TRADE CENTRE AND AN ECONOMIC CENTRE?the relationship among the “four centres” is “3+1”,once the trade centre, financial centre and logistics centres are established, the economic centre is naturally formed. 9 See X, Planning key to free-trade zones (editorial), South China Morning Post (11 June 2014).

from exchange rate appreciation and increased labour costs, weak external demand

owing to the slow recovery from the global financial crisis, the increasing trade

frictions and the complicated customs regulatory processes that continue to turn away

foreign capital and discourage domestic investment.10

The development of the CSPFTZ builds on Shanghai’s strengths such as its excellent

geographical location in terms of shipping and access to a vast and dynamic

hinterland.11

The choice for Shanghai as the location for China’s push to host one of

the world’s premier tier financial centres also reflects the current reality of Shanghai

as the de facto capital of finance of China.12

Shanghai hosts the headquarters of the

Bank of Communications and the Pudong Development Bank. The financial

operations and the back office operations of respectively the China Industrial Bank

and the China Ping’an Insurance Company are based in Shanghai. It is home to the

Shanghai Stock Exchange, the Shanghai Futures Exchange, the Shanghai Gold

Exchange, China Union Pay, the Foreign Exchange Trade System and the Interbank

Market. It is then not surprising that it is the leading city in terms of the number of

foreign financial institutions seeking a base in China.13

At the Third Plenary Session of the 18th Central Committee of the Communist Party

of China (2013), a ‘National Leading Group for Comprehensive Deepening Reform’

was established. Among the responsibilities of this Group is the development of the

CSPFTZ.14

The Group is headed by President Xi Jinping and will take responsibility

for the national policy design, inter-departmental and regional coordination and the

implementation and supervision of major reform across sectors in furthering China's

reform process.15

The WTO Trade Policy Review Report lists the initial achievements of the CSPFTZ

as reported by the Chinese authorities. It reveals that in the period from September

2013 until mid-February 2014, 434 foreign-invested enterprises were established

representing a total investment of US$1.8 billion. It was reported that these investors

come from 40 different countries. The investments have been strongly attracted to

services, including 89 financial companies were set up and 34 financial leasing

10 Foreign companies have gradually moved their bases from the eastern coastal area to regions and countries that have low manufacturing costs(Beresford et al.,2012) (Yang et al., 2010), 11 See Yizhi Wang, Hiroyuki Shibusawa, Edward Leman, Yoshiro Higano & Gouping Mao, A Study of Shanghai’s Development Strategy to 2020, 5(2) Regional Science Policy & Practice 183 (2013). 12 See Anindya K. Bhattacharya, The Feasibility of Establishing an International Financial Center in Shanghai, 12 Journal of Asia-Pacific Business 123-124 (2011). 13 See Yizhi Wang, Hiroyuki Shibusawa, Edward Leman, Yoshiro Higano & Gouping Mao, A Study of Shanghai’s Development Strategy to 2020, 5(2) Regional Science Policy & Practice 186 (2013). 14 See WTO, Trade Policy Review China – Report by the Secretariat (WT/TPR/S/300) (27 May 2014), at 10; X, China's reform leading group holds first meeting (China Daily, 23 January 2014) 15 See Third Plenary Session of the 18th CPC Central Committee, The Decision on Major Issues Concerning

Comprehensively Deepening Reforms (12 November 2013) (abridged translation). Is there any public information

available about this Group? How many members? Who? Any public information on their activities? Reports?

Statements?

companies. The Zone currently represents 27% of Shanghai's total trade (exports and

imports).16

As the title of the free trade zone indicates, this is a pilot project. Shanghai was

chosen as the location for the pilot project as in previous cases with bonded zones and

free trade ports. The pilot project has an initial period of two to three years to test

further trade and investment liberalization with a focus on services, including testing

new modes of services and new forms of supervision.17

The experience gained

through this pilot project is to serve nationwide as a model for new ideas, new

approaches and further reform.18

It is a strategic plan to ensure a more effective and

efficient domestic financial sector (‘serving the nation’) and to further the

internationalization of China’s financial sector (‘going to the world’).19

The pilot

project allows experimentation ‘step by step with risks under control’.20

To date,

more than 20 cities have a declared interest in being next in line when the results of

this pilot are rolled out further, including Shenzhen, Tianjin, Qingdao, Chongqing and

Xi’an. However, these new applications have been stopped by the Central government

since they are still waiting for CSPETZ to show a ‘duplicable and replicable

experiences’ and real impact.21

This article aims to review the regulatory aspect aspects of the financial reforms in the

CSPFTZ and the arrangement for regulatory oversight. The first section reviews the

regulatory framework and concludes that it does not yet meet international standards

in terms of legal certainty, legal clarity and transparency and meaningful stakeholder

involvement.22

No detail – the detail is to follow – most likely in a responsive mode: as problems or

questions occur, the question is pushed up the chain to receive a response.

2. CSPFTZ Financial Services Liberalisation: Law and Institutions

2.1 Law and Institutions

16 WTO, Trade Policy Review China – Report by the Secretariat (WT/TPR/S/300) (27 May 2014), at 51. 17 See Article 2 (Overall Objectives), Decision of the State Council, Framework Plan for the China (Shanghai) Pilot Free Trade Zone (27 September 2013). 18 See Article 2 (Overall Objectives), Decision of the State Council, Framework Plan for the China (Shanghai) Pilot Free Trade Zone (27 September 2013). 19 See chapeau of Title 2, Decision of the State Council, Framework Plan for the China (Shanghai) Pilot Free Trade Zone (27 September 2013). 20 See chapeau of Title 2, Decision of the State Council, Framework Plan for the China (Shanghai) Pilot Free Trade Zone (27 September 2013). 21News of the Xinhua net(Chinese version) http://news.xinhuanet.com/politics/2014-06/03/c_126575983.htm Actually, this FTZ fever in China was originated from a formulation in the “Decision” of the Third Plenary Session of the 18th CPC Central Committee, that is “Based on practices in the China (Shanghai) Pilot Free Trade Zone, a number of qualified areas will be built into FTAs.”(Article 24). However, some local governments are pursuing merely the preferential policies. It goes counter to the original intention of the central government which focuses on system innovation, deepen reform and further open up. 22

See also X, Planning key to free-trade zones (editorial), South China Morning Post (11 June 2014). The editorial summarises the problems cogently: ‘The special measures outlined to attract foreign investors are short on detail. A "negative list" of areas and activities off-limits to investors runs to more than 1,000 items, leaving much red tape and a commercial legal framework and freedoms to do business that fall far short of international standards.’

The policy framework for the liberalisation of financial services is the decision of the

Third Plenary Session of the 18th

Central Committee of the Communist Party of

China.23

As part of the reform into a socialist market economy, a direction is charted

to a modern market system with open, fair and transparent rules and markets-based

prices.24

Even though there are some exceptions to this development, financial

services fall squarely within the policy and have been targeted for reform.25

These

reforms include allowing qualified private capital to set up financial institutions under

enhanced supervision with a deposit insurance system and a market-based exit system,

improve the market-based exchange rate formation mechanisms for the RMB and

accelerate interest rate liberalisation.26

Whereas the policy direction is given by the Central Committee, the legal basis for the

establishment of the CSPFTZ is provided by the 2013 decision of the State Council in

pursuance of the afore-mentioned policy by issuing the Framework Plan for the China

(Shanghai) Pilot Free Trade Zone.27

The Guiding Principles of the Framework Plan

provide that the CSPFTZ ‘will create a regulatory environment on cross-border

investment and trading that is in line with international practices, enhance China's

economic position globally, and contribute to achieving the revival of the Chinese

People's China Dream’.28

The fourth ‘major tasks and measures’ of the Framework

Plan deal specifically with strengthening innovation and further liberalization of

financial services.29

This strategy is focused on positioning Shanghai as a full-service

international financial centre and internationalizing the RMB by opening up the

CSPFTZ for private investors and foreign-invested and Sino-foreign financial

institutions and by allowing financial innovations (including new areas of financial

activities for China such as commodity futures trading, equity escrow, and

cross-border RMB reinsurance).30

The Circular on the Framework Plan delegates the responsibility for the

implementation of the Framework Plan to the Shanghai Municipal People's

Government. 31

23

Insert reference 24

Insert reference 25

Insert reference which exceptions? 26 See Third Plenary Session of the 18th CPC Central Committee, The Decision on Major Issues Concerning

Comprehensively Deepening Reforms (12 Nov 2013) (abridged translation), para. 18. 27 See Decision of the State Council, Framework Plan for the China (Shanghai) Pilot Free Trade Zone (27

September 2013). 28 Insert reference. Why revival? 29 The other three are: (1) Accelerate the functional transformation of government; (2) Opening up of investment

sectors; (3) Promote the transformation of trade development approach; and (5) Improve regulatory supporting

systems 30 Decision of the State Council, Framework Plan for the China (Shanghai) Pilot Free Trade Zone (27 September

2013). 31 See Circular of the State Council on the Framework Plan for the China (Shanghai) Pilot Free Trade Zone (18

September 2013).

Whereas the delegation to the Shanghai Municipal People’s Government is explicitly

stated in the Framework Circular, there is also some informal delegation of powers for

the development of rules to the relevant agencies and bodies, in particular the People’s

Bank of China and to the three regulatory bodies of the financial sectors, the China

Banking Regulatory Commission, the China Securities Regulatory Commission and

the China Insurance Regulatory Commission. These bodies develop regulations on

financial services liberalisation by issuing circulars and ‘policies and measures’.

These documents are quasi-legal in nature but they are in practice the applicable legal

rules in the absence of being overruled.32

However, these documents merely

represent a further layer in the regulation in that they provide further implementation

of the strategy but do not provide detailed rules. Examples include multiple references

to ‘qualified foreign-invested banks’ or ‘conditioned banks’ but the conditions for

qualification are left to decided.

A further level of details is to be developed by the municipal government of

Shanghai, Shanghai Head Office of the PBC, China(Shanghai) Pilot Free Trade Zone

Administration, others can develop detailed rules and procedures.

Insert paragraph on the institutions responsible for the implementation and

functioning

2.2 The Opinion of the People’s Bank of China (PBC Opinion)

The People’s Bank of China is the highest level of implementation of the CPC Central

Committee and State Council Decisions. It provides the three general principles that

underpin the financial reforms33

:

1. The principle of the financial sector serving the real economy will be followed

to further facilitate trade and investment, promote the opening of the financial

sector and to facilitate the FTZ to compete internationally on a higher platform.

2. The principle of continuing reform and innovation, and leading the way in pilot

will be followed to promote the cross-border use of RMB, the move towards

capital account convertibility, market-based interest rate reform and

foreign exchange administration reform.

3. The principle of keeping risks within controllable ranges and making steady

progress will be followed to organize experiments in an orderly manner whenever

the conditions for an experiment are mature.

32 See Peter Howard Corne, Creation and Application of Law in the PRC, 50 American Journal of Comparative

Law 372 (2002). See generally Robert Guillaumond, Lu Jianping & Li Bin, Droit chinois des affaires 51-121

(Brussels : Larcier, 2013) 33 Opinions of the PBC on Financial Measures to Support the China (Shanghai) Pilot Free Trade Zone

(unofficial translation, edited)

The principles reflect the two main concerns. The first concern is to learn the lessons

from the 2008 financial crisis by developing a cautious approach to financial

liberalisation and to develop rules and regulations that aim to avoid speculative

financial transactions by emphasising the linkage with the ‘real economy’ and by

avoiding the pitfalls of the too-big-to-fail experiences in US and EU markets.34

The

second is to strengthen the market-reform and the internationalisation of China’s

financial sector, including the internationalisation of the RMB and the integration of

the Chinese financial sector into the international markets.

The principles reveal important elements of the strategy. The reform and innovation

process will be a gradual process. The objective is to keep the process under control

and the steer its course. The purpose is to bring financial sector out of the state

protective umbrella. This liberalisation is to support a reform of the Chinese financial

sector and to facilitate its development into a sector that can sustain international

competition. The facilitation of the CSPFTZ to compete internationally on a higher

platform should be interpreted as a strategy of knowledge and know-how transfer and

acquisition. By allowing foreign financial institutions to operate in the CSPFTZ and

allowing them to enter into joint ventures, the Chinese financial institutions are forced

to meet these increasingly higher benchmarks and become competitive at the

international level as part of the efforts to make Shanghai a premier international

financial centre built on Chinese financial institutions.

The second key element in the strategy is to position the renminbi as an international

currency. This requires that the exchange of the renminbi is gradually released from

strict controls and that the interest-rates are brought in line with the expectations of

the market. The liberalisation of the usage of the renminbi includes the promotion of

its cross-border use beyond simple trade payments. The most recent policy statement

of the Shanghai Head Office of the PBOC was released on 21 February 2014 in the

form of a ‘Notice on the support of China (Shanghai) free trade zone to expand

cross-border RMB test used’.35

The Notice ….

The third key element concerns oversight and risk-management. It forestalls a

wholesale review of the regulatory system. This issue will be discussed in the second

part of this article.

2.3 The Circular of the China Banking Regulatory Commission (Banking

Circular)

Banks operating in the CSPFTZ are not subject to the restrictions that are in force in

China generally. The China Banking Regulatory Commission explains the effect of

these changes for Chinese-funded banks and for qualified foreign-invested banks.36

34

Insert reference.to academic literature on ‘real economy’ link and financial crisis 35

http://shanghai.pbc.gov.cn/publish/fzh_shanghai/2974/2014/20140221174612080116226/20140221174612080116226_.html 36 Circular of the China Banking Regulatory Commission on Issues Concerning Banking Supervision in China

National Chinese-funded commercial banks, policy banks and banks in Shanghai can

benefit from this new regulatory environment by setting up new branches or special

institutions in the CSPFTZ, or by upgrading their existing presence to a branch or

sub-branch.37

Qualified foreign-invested banks are similarly allowed to set up subsidiaries, branches

or special institutions or to upgrade existing sub-branches to branches. Qualified

foreign-invested banks can also set up Sino-foreign equity joint-venture banks.38

As

for Qualified foreign-invested banks, strict regulation applies in terms of the

time-periods required to set up a branch by the representative office of a foreign bank

in the CSPFTZ and to be allowed to carry out RMB business. The Circular indicated

that a shortening of the time-periods will be studied. For setting up sub-branches the

pre-approval procedure will be replaced by a reporting requirement for the

qualifications of the branch office, the senior management and certain business

permission.39

“A "green channel" will be set up to grant the market access for

banking industry in the FTZ to enhance the administration efficiency by setting

time limits for certain items.” According to the WTO TPR, the Chinese authorities

have explained that "Green Channel" means “streamlining the market access

procedures for financial institutions by optimizing the supervision mechanism, so as

to promote opening and competition among banks and financial institutions within the

CSPFTZ”.40

The Banking Circular clarifies that qualified private investors can enter the banking

sector in the CSPFTZ. They can set up banks, finance leasing companies, consumer

finance companies and other finance institutions but they shall assume their own

risk.41

They can also participate in setting up Sino-foreign equity joint-venture banks

with other Chinese or foreign financial institution investors.42

As was shown for private investors, the Banking Circular is not limited to banking but

encompasses financial services in a wider sense and particular when it concerns

cross-border investment and financing services. The activities of banking financial

institutions supported by the China Banking Regulatory Commission include

(Shanghai) Free Trade Zone, Yin Jian Fa [2013] No. 40, of 28 September 2013 (English translation – Chinese original version prevails) [hereinafter Banking Circular], 37 Article 1 Banking Circular. Policy Banks were established by the Decision of the State Council on Reform of the Financial System (25 December 1993) carrying out the decision of the Third Plenary Session of the Fourteenth Central Committee. The policy banks were established to separate policy finance from commercial finance. They are guided and supervised by the PBOC. There are 3 policy banks in China: China Development Bank, The Export-Import Bank of China, Agricultural Development Bank of China. 38 Article 3 Banking Circular. 39 Article 7 Banking Circular 40 WTO, Trade Policy Review China – Report by the Secretariat (WT/TPR/S/300) (27 May 2014), footnote 63. 41 As a corollary to this, a deposit insurance guarantee is envisaged. See Third Plenary Session of the 18th CPC Central Committee, The Decision on Major Issues Concerning Comprehensively Deepening Reforms (date) (abridged translation), para. 18. 42 Article 4 Banking Circular.

cross-border financing business, including but not limited to commodity trade finance,

whole supply chain finance, offshore vessel finance, financial support to modern

service sectors, onshore loans against offshore guarantees and commercial

instruments. This list in the Banking Circular is not a closed list. Furthermore,

banking financial institutions are supported to promote finance services for

cross-border investments, including but not limited to cross-border M&A loans and

project loans, guaranty for offshore loans, cross-border assets management and wealth

management business and real estate investment trust. Again this list is not

limitative.43

Beyond banking and financial institutions, the Banking Circular also contains rules on

the operations of qualified large enterprise groups in the CSPFTZ that are allowed to

establish group finance companies and that qualified investors can set up auto finance

companies and consumer finance companies in the CSPFTZ.44

Finally the Banking Circular provides that trust companies established in Shanghai

are permitted to relocate into the CSPFTZ; that national financial asset management

companies may establish branches in the CSPFTZ and that finance leasing companies

may establish specialised subsidiaries.45

2.4 The Policies and Measures on the Capital Market of the China Securities

Regulatory Commission (Policies and Measures).

The objectives of Commission as explained in this document are to deepen the capital

market reform, further promote the opening-up and support the CSPFTZ. The

Commission indicates that this process will require further research and refinement of

the Policies and Measures. But it stresses the need for speedy implementation.

The Policies and Measures allow the Shanghai Futures Exchange to establish a

Shanghai International Energy Trading Center Co., Ltd. in the CSPFTZ. This Energy

Trading Center will set up a trading platform for international crude oil futures. This

trading platform will also be open to foreign investors.

Most of the Policies and Measures give a cautious direction for reform rather than a

set of rules. The areas opened up are encapsulated in caveats and conditionalities

making it difficult to achieve the speedy implementation referred to in the document.

The Policies and Measures invariably include the ‘qualified’ and reference to

‘relevant regulation’ without either being defined, leaving uncertainty is to the

implementation of these reforms.

Further specific reforms include the possibility for qualified investors (companies and

individuals) to make investments in foreign and domestic securities and futures

43 Article 5 Banking Circular. 44 Article 2 Banking Circular. 45 Article 3 Banking Circular.

markets; the possibility of foreign parents of enterprises in the CSPFTZ to issue RMB

bonds in domestic markets (in accordance with relevant regulations); the possibility

for securities and futures institutions to register and set up specialized subsidiaries in

the CSPFTZ; and the possibility for securities and futures institutions in the CSPFTZ

to carry out over-the-counter transactions of commodities and financial derivatives for

domestic clients.

2.5 The Opinion by the China Insurance Regulatory Commission to Support

the China (Shanghai) Pilot Free Trade Zone (Insurance Opinion)

The Insurance Opinion comes in the form of a reply to undisclosed questions from its

Shanghai Bureau. It lists eight areas where the China Insurance Regulatory

Commission (CIRC) will support reform. The CIRC will support the establishment of

foreign-invested specialised health insurance institutions in the CSPFTZ; it will

support the establishment of branches of insurance companies; it will support an

outbound investment pilot for CSPFTZ insurance institutions; it will support the

development of reinsurance business in the CSPFTZ by world-known specialized

insurance intermediaries as well as social organizations or individuals and it will

support the development of cross-border RMB-denominated reinsurance business in

the CSPFTZ; it will support the development of shipping insurance business in

Shanghai, including development of shipping insurance institutions and shipping

insurance brokers; and development of the Association of Shanghai Shipping

Insurance;

In more general terms, the CISC will support innovation in insurance products by

insurance companies and the continuous expansion of the service scope of liability

insurance business. It will strive to improve the insurance market system in Shanghai

and to promote the establishment of functional insurance institutions such as shipping

insurance pricing centre, reinsurance centre, insurance fund management centre, etc.

The overall objective of the reforms in the insurance market is to establish a

mechanism linking the financial reform and innovation in the CSPFTZ with the

building up of Shanghai International Financial Centre.

With controlling financial system risks, there would be no longer QFII, RQFII.

Enterprises in Shanghai FTZ would invest in securities and futures. Individuals could

directly invest in overseas securities market without QDII constraints. The institutions,

which provide financial services to entities in Shanghai FTZ, is not limited in the zone,

but in Shanghai46

. Financial opening is one of important contents in China (Shanghai)

Pilot Free Trade Zone. Under the premise of risk control, by implementing the

“central bank 30” and other polices, the financial services sector should be further

46 People's Bank of China. Opinions of the People's Bank of China on Financial Supporting China (Shanghai) Pilot

Free Trade Zone. December 2, 2013. More Details ：http://zbw.sh.gov.cn/WebViewPublic/item_page.aspx?newsid=635215802017535000&coltype=8

opened up in Shanghai FTZ, to accelerate the financial innovation, strengthen the

service function of finance, and support of the Shanghai trade zone at high platform to

participate in international competition.

Meanwhile, financial opening would also lead to inter-kingdom protoplast fusion

between banking, security, insurance and other financial businesses. Nowadays,

financial holding corporations in integrated operation become the general trend,

which calls for new requirements for the current financial supervision system.

Therefore, it is in urgent need for in-depth study on financial opening and integrated

supervision innovation in Shanghai FTZ. Besides, as the global continuous reflections

from the financial crisis, constructing proper financial supervision system in Shanghai

FTA is particularly important. It is foreseeable that financial institutions in the region

would have more degrees of freedom. With the deepening open up in financial

services industry, it will greatly increase the financial risk and affect the stability of

the financial market. State Council and the central bank emphasize that the financial

opening should be under controllable risk, especially the systematic risk. It means that

it needs to establish a supervision and management system to adapt to open of the

financial market. Therefore, it is necessary to perfect the regional financial

supervision legislation system, strengthen the macro prudential supervision, and

establish a suitable supervision institution. For these specific financial opening areas,

it has to explore appropriate supervision framework on offshore financial business,

interest rate marketization, and capital account liberalization. On the other hand, only

with a strong and effective supervision system, could better and deeper opening be

achieved. Otherwise, struggle for opening financial services sector in Shanghai FTA

would be in vain.

3. Financial Supervision in China and CSPFTZ

3.1 Financial Supervision in China

The People’s Bank of China was established in 1948 as a merger between of three

existing commercial banks, Huabei Bank, the Beihai Bank and the Xibei Farmer

Bank.47

From 1950 until 1979, the PBOC was the sole bank in China functioning

both as a central bank and as a commercial bank.48

In 1980, the commercial banking

activities were split off from the PBOC and transferred to four state-owned

commercial banks: the Bank of China (BOC), the China Construction Bank (CCB),

the Agricultural Bank of China (ABC) and the Industrial and Commercial Bank of

China (ICBC).49

The role of the PBOC was redefined with a dual function. The first

was to develop monetary policy. The second was the regulation and supervision of the

banking sector, including banking, insurance and securities.50

However, owing to

the mixed operations in the financial sector and the rapid development of the

47 Insert ref 48 Insert ref 49 Insert ref 50

banking and trust industries, a certain amount of chaos ensued. In 1992, the

China Securities Regulatory Commission (CSRC) was established and in 1998, the

China Insurance Regulatory Commission (CIRC).51

The current system of financial supervision in China was established in 2003 when

the Tenth National People’s Congress Standing Committee approved a proposal of the

State Council to separate banking regulation and supervision from the People’s Bank

of China and entrust it to a new body, the China Banking Regulatory Commission

(CBRC).52

The CBRC is the principal regulatory and supervisory body for the

banking sector and is directly accountable to the State Council.53

It is not subordinate

to the PBOC that maintained its role of the guardian of monetary policy but stands on

an equal footing with it; each has its distinct function and role in the supervisory

system.54

The separation was aimed at providing greater independence to the PBOC

in terms of developing monetary policy as it would no longer have to deal with

conflicts of interests between monetary policy and its role as a banking regulator.55

Additionally, the PBOC has delegated its task to regulate and supervise the foreign

exchange market to the State Administration of Foreign Exchanges (SAFE) that it

oversees.56

Further of relevance to supervision in the banking sector and especially in

relation to the operations of foreign banks are the Ministry of Finance, the National

Development and Reform Commission (NDRC) and the State-owned Assets

Supervision and Administration Commission (SASAC)57

Some authors have indicated as a weakness that the role of local regulatory and

administrative bodies is unclear and that this could be confusing to foreign

institutions.58

The fact that the main regulatory bodies are based in Beijing might

further diminish the regulatory power of Shanghai and risks allowing for a divergence

between the Shanghai realities on the ground and the policy perceptions and

formulations in Beijing.59

This means that China has not followed the dominant model that had spread to most

51 See Charles C.C. Chau, The new watchdog for the banking and financial industry in China: the China Banking Regulatory Commission, 8(?) Journal of International Banking Law and Regulation 335 (2003). 52 Wei Ping He, Banking regulation in China: what, why, and how?, 20(4) Journal of Financial Regulation and Compliance 368 (2012). 53 Wei Ping He, Banking regulation in China: what, why, and how?, 20(4) Journal of Financial Regulation and Compliance 368 (2012). 54 Article 2, Law of the People's Republic of China People's Bank of China 1995. 55 It has been suggested that the PBOC set interests rates with the interests of major banks in mind rather than inflation targets for the country. See Charles C.C. Chau, The new watchdog for the banking and financial industry in China: the China Banking Regulatory Commission, 8(?) Journal of International Banking Law and Regulation 337 (2003). 56 57 See Wei Ping He, Banking regulation in China: what, why, and how?, 20(4) Journal of Financial Regulation and Compliance 369 (2012). 58 Yizhi Wang, Hiroyuki Shibusawa, Edward Leman, Yoshiro Higano & Gouping Mao, A Study of Shanghai’s Development Strategy to 2020, 5(2) Regional Science Policy & Practice 192 (2013). 59 Yizhi Wang, Hiroyuki Shibusawa, Edward Leman, Yoshiro Higano & Gouping Mao, A Study of Shanghai’s Development Strategy to 2020, 5(2) Regional Science Policy & Practice 192 (2013).

jurisdictions namely a single regulator or a twin peaks model.

Due to the specific situation of China, the systemic risks are assessed in a different

framework as the execution of the planned developments can receive a higher priority

over systemic risks as long as these systemic risks can be covered by the central

government. This has led to a higher level of non-performing debt and of inefficient

banks as would be tolerable in different circumstances. As the planning provides for a

marketization of the financial sector, these risks have to be brought in line with

international practice.

The CSPFTZ is the pilot project where this process of bringing the financial sector in

line with international standards is being tested. This process has two elements. The

first is the development of suitable regulations as discussed above. The second is the

monitoring and enforcement of these regulations.

3.2 Brief Overview of Regulators in Other Financial Centres

The CSPFTZ is a strategy to position Shanghai is a premier international financial

centre. It is therefore relevant to briefly review the supervisory arrangements at the

international financial centres with whom it enters into competition, in particular

London, New York and Tokyo. To a lesser extent, also Hong Kong and Singapore are

relevant in this discussion.

The supervision of the financial sector can be organized in a variety of ways. There

are jurisdictions that favoured a single regulator, like the Financial Services Authority

(FSA) (UK).60

Some jurisdictions prefer multiple specialized regulators, like the US

with supervisory roles given to the Federal Reserve (central bank), the Securities and

Exchange Commission and the Commodity Futures Trading Commission. However,

these supervisory mechanisms proved flawed in the light of the 2009 financial crisis.

Despite the FSA being followed as a model of best practice, the UK abolished the

organization and brought the regulatory supervision task under the Bank of England

(central bank).61

Add Tokyo, HK and Singapore

Hong Kong

• Banking

Hong Kong’s banking sector comprises three tiers of authorized institutions(AIs):

licensed banks, restricted licence banks and deposit-taking companies. The Hong

Kong Monetary Authority(HKMA) ensures general stability and effective working of

the banking system through the regulation of banking and deposit-taking business and

the supervision of AIs. The HKMA has responsibility to promote proper standards of

60 The Financial Services Authority was established in 1997 and discontinued in 2010. 61 Insert ref

conduct, encourage sound and prudent business practices, and to help prevent illegal,

dishonourable or improper practices in the banking industry. The HKMA derives its

regulatory powers from the Banking Ordinance. The HKMA has a general discretion

under the Banking Ordinance to grant or refuse an application for authorization to

operate a banking business or the business of taking deposits in Hong Kong.

As to the supervision methods, the HKMA adopts a “continuous supervision” policy

to supervise banks, and its main objective is to detect and address a problem at an

early stage. This involves monitoring the businesses of the AIs through a variety of

techniques, including: on-site examinations; off-site reviews; prudential meetings;

meetings with the board of directors; co-operation with external auditors; sharing

information with other supervisors. Furthermore, the HKMA adopts a risk-based

approach to banking supervision to ensure that AIs have the necessary risk

management systems to identify, measure, monitor and control risks inherent in their

business operations, and address any problem at an early stage. The HKMA has

identified eight major types of inherent risk: credit risk, interest rate risk, market risk,

liquidity risk, operational risk, legal risk, reputation risk and strategic risk.

• Securities

Under the present regulatory framework, the Securities and Futures Commission

(SFC), which is the “lead regulator” for the securities industry, sets out the principles

and regulatory requirements for all intermediaries to follow. An AI wishing to engage

in securities intermediary activities must register with the SFC. When an AI applies to

be registered, the HKMA will advise the SFC whether the AI is fit and proper for this

purpose. Being the “frontline regulator” of AIs’ securities business, the HKMA is

responsible for supervising the securities business conducted by the AIs, and where

necessary, issuing circulars to AIs to supplement the SFC’s regulatory requirements

on the basis of the HKMA’s supervisory experience and the nature of operations of the

AIs.

To facilitate co-operation on supervising AIs’ securities business, the HKMA and the

SFC have entered into a Memorandum of Understanding setting out their roles and

responsibilities.

Singapore62

-Single Regulator

• Monetary Authority of Singapore

As Singapore's central bank, the Monetary Authority of Singapore (MAS) is an

integrated supervisor overseeing all financial institutions in Singapore -- banks,

insurers, capital market intermediaries, financial advisors, and the stock exchange. It

conducts integrated supervision of financial services and financial stability

surveillance. With its mandate to foster a sound and progressive financial services

sector in Singapore, MAS also helps shape Singapore's financial industry by

promoting a strong corporate governance framework and close adherence to

62

See the official website of Monetary Authority of Singapore, http://www.mas.gov.sg/

international accounting standards. As to the specific financial regulation of different

institution, there are particular departments inside the MAS supervising the

businesses.

• Banking and Insurance

Banking Departments I, II and III

The three Banking Departments collectively supervise licensed and regulated banks,

merchant banks, finance companies, money changers and remittance agents in

Singapore. They foster the stability and strength of Singapore's financial system by

monitoring the safety and soundness of the financial institutions that they supervise,

and promoting the adoption of international best practices in corporate governance

and risk management. Broadly, Banking Department I supervises the local banking

groups on a consolidated basis, and certain foreign banks. Banking Department II

supervises a mix of retail and wholesale banks, finance companies, money changers

and remittance agents. It also houses the Supervisory, Methodologies, Transactions

and Analytics Division. Banking Department III generally supervises banks active in

treasury and private banking businesses.

Insurance Department

The Insurance Department supervises and regulates insurance companies and has as

its primary objective the protection of policyholders' interests. The department adopts

a risk-focused approach in the prudential and market conduct supervision of insurance

companies. In its standards setting role, the department works closely with industry

associations to promote the adoption of best practices by the industry.

• Capital Markets

Capital Markets Intermediaries Department

The Capital Markets Intermediaries Department has responsibility for the admission

and supervision of capital markets intermediaries, including securities dealers and

futures brokers, fund managers, corporate finance advisers, and financial advisers. It

administers the licensing and business conduct rules for these intermediaries under the

Securities and Futures Act, and Financial Advisers Act. The department is also

responsible for regulating insurance brokers under Part IIB of the Insurance Act.

Investment Intermediaries Department

The Investment Intermediaries Department has responsibility for the admission and

supervision of investment intermediaries, including fund managers, Real Estate

Investment Trusts managers and trust companies; and credit rating agencies. It

administers the licensing and business conduct rules for these intermediaries under the

Securities and Futures Act and Trust Companies Act.

Market Conduct Department

The Market Conduct Department has supervisory responsibility for capital markets

through the administration of the Securities and Futures Act, the Business Trusts Act

and the Singapore Code on Take-overs and Mergers. It regulates (i) the offering of

securities, business trusts, Real Estate Investment Trusts and collective investment

schemes; (ii) the conduct of takeover and merger transactions; and (iii) SGX as a

listed entity. It also enforces the civil penalty regime for market misconduct.

Markets Policy & Infrastructure Department

The Markets Policy and Infrastructure Department has supervisory responsibility for

markets and infrastructures including central counterparties and trade repositories.

The department formulates and implements policies in relation to markets and

infrastructures, as well as market and business conduct policies to achieve fair

outcomes for depositors, investors and policyholders. It is also responsible for

formulating MAS' positions on competition issues and corporate governance

standards.

• Policy, Risk and Surveillance

Prudential Policy Department

The Prudential Policy Department formulates capital and prudential policies for banks,

insurance companies and securities firms to promote a sound and dynamic financial

sector in Singapore. The department develops capital standards for the financial sector,

including MAS’ approach on the implementation of Basel III. It also formulates MAS’

policies on housing loans and unsecured credit, concentration limits, and the deposit

insurance and policy owners’ protection schemes. It reviews MAS’ policy on banking

structures and strengthens the regulatory frameworks for banks, merchant banks,

finance companies, and financial holding companies.

Specialist Risk Department

The Specialist Risk Department provides risk expertise for the effective prudential

supervision of Singapore's financial sector. The department monitors and assesses the

risk management processes and controls of individual financial institutions and

designated payment systems. It also keeps track of systemic macroprudential risks of

the financial industry and formulates efficient approaches to deal with the risks

identified. Areas of focus include (i) financial risks comprising credit, market,

liquidity and operational risks; (ii) technology risk including IT systems and security

controls, (iii) business continuity management; and (iv) payment systems and

infrastructure.

Macroeconomic Surveillance Department

The Macroeconomic Surveillance Department conducts surveillance of the financial

system to identify emerging trends and potential vulnerabilities, and closely monitors

and evaluates developments in G-3 and regional economies, as well as international

financial markets. The department undertakes in-depth policy-relevant studies on

macro-financial linkages, systemic risk and other financial stability issues. It works

closely with MAS' supervisory departments to ensure that both macro and

micro-prudential perspectives are brought to bear on financial stability issues.

London——from single regulation to “twin peak” regulation

In order to adapt to the mixed operation in financial industry, the England government

reformed the financial supervision system in 1997, unifying the supervision

authorities of 9 financial institutions including bank of England into a single

institution. In Oct 1997, Financial Service Authority (FSA) was set up, who is

responsible for the regulation and prudential supervision of banking, building

societies, credit unions, insurers and major investment firms.

After the financial crisis of 2008, a new regulatory framework for the United

Kingdom’s financial sector came into effect in April 2013. Since 2013, the FSA has

become two separate regulatory authorities: the Financial Conduct Authority (FCA)

and the Prudential Regulation Authority (PRA). The PRA works alongside the

Financial Conduct Authority (FCA) creating a “twin peaks” regulatory structure in the

UK. The PRA will co-operate closely with the FCA. The key principle underlying this

co-operation will be that each authority should focus on the key risks to its own

objectives, while being aware of the potential for concerns of the other. Separate

mandates of the PRA and FCA for prudential and for conduct regulation will allow

both regulators to apply more focus to their respective areas than has previously been

the case. 63

The FCA regulates the financial service industry in the UK. The FCA is a separate

institution and not part of the Bank of England. The FCA is responsible for promoting

effective competition, ensuring that relevant markets function well, and for the

conduct regulation of all financial services firms. This includes acting to prevent

market abuse and ensuring that consumers get a fair deal from financial firms. The

FCA operates the prudential regulation of those financial services firms not

supervised by the PRA, such as asset managers and independent financial advisers.64

The PRA was created by the Financial Services Act (2012) and is a part of the Bank

of England and responsible for the prudential regulation and supervision of banks,

building societies, credit unions, insurers and major investment firms. It aims

through its supervision to develop a rounded, robust and comprehensive view of these

firms, to judge whether they are being run in a safe and sound manner, and whether

insurers are protecting policyholders appropriately. It sets standards and supervised

financial institutions at the level of the individual firm. The PRA’s most significant

supervisory decisions are taken by its Board – comprising the Governor of the Bank

of England, the Deputy Governor for Financial Stability, the Chief Executive Officer

of the PRA (and Deputy Governor for Prudential Regulation), and independent

non-executive members. The Board is accountable to Parliament. 65

63

See Andrew Bailey, Sarah Breeden and Gregory Stevens, Bank of England Quarterly Bulletin 2012 Q4. 64

See the official website of FCA: http://www.fca.org.uk/ 65

See the official website of PRA: http://www.bankofengland.co.uk/Pages/home.aspx

3.3 Financial Supervision in the CSPFTZ

However, this is due to the specific structure of China’s financial system, and the

main source of financial market risk is not systemic risk. In addition, the difference

between financial institutions will continue to exist in the future for a long period,

which decides that the separated supervision suits to China. Based on the actual

supervision effect, segregate supervision system promotes the development of

financial industry. ○1 Improves the professionalism and independence of financial

regulators, and clears the regulating responsibility of different regulators; ○2

Improves the professionalism of China's financial institutions. From the actual

regulatory effect, under the guide of regulators, financial institutions carried out the

market-oriented reform, improved the corporate governance system, and the further

developed the main business. The financial sector is under increasing development;

○3 Isolates the financial risks effectively, and maintains the stability of the financial

system.

Although it suits the general need of the development of China's financial system, and

also plays a huge role, the segregate supervision system may not meet the actual

needs of Shanghai FTZ. If the segregate supervision system was applied in Shanghai

FTZ, the inherent disadvantages would be amplified. ○1 Segregate regulation may

lead to higher financial regulatory costs and lower efficiency. Thus segregate

supervision could hardly master the comprehensive financial status in Shanghai FTZ,

take timely measures, and effectively response to systemic financial risk; ○2 Because

of the deepening financial liberalization, mixed financial products and groups will

continue to appear, segregate regulation would lead to lack of supervision or over

regulation; ○3 It is easy to accumulate systemic risk under segregate regulation, due

the lack of macro prudential supervision.

3.1.2. the Overall Financial Supervision in Shanghai FTZ

Although the financial supervision and legal rules haven’t been all issued in Shanghai

FTZ, financial supervision should focus on the protection of public investors and

eliminating the negative externalities of the financial crisis. Regulators shall be

authorized clearly to be responsible for financial supervision in Shanghai FTZ.

Therefore, in the reform practice in Shanghai FTZ, an inevitable requirement is to

implement macro and micro prudential and effective supervision on financial services

industry. Financial supervision mode in Shanghai FTZ shall not copy the western

financial supervision mode or continue the existing regulatory system. The financial

supervision mode shall be compatible with the actual situation of financial

development in Shanghai FTZ.

Single regulator pattern refers to the entire financial system is regulated by a single

regulatory authority, and it would be in charge of protecting public investors. For

Shanghai FTZ, a relatively small financial market, a single regulator could supervise

more comprehensively. Appling a single regulator in Shanghai FTZ has the many

advantages. ○1 A unified regulatory system can be established to form supervision

economical scale and avoid regulatory loopholes or regulatory overlap; ○2 Regional

financial institutions could be under more comprehensive regulation. A single

regulator could comprehensively review and assessment the compliance and potential

risk of regional financial institutions, which helps in reducing the management cost

and forming economical scale of supervision; ○3 Compared to segregate regulation,

a single regulator allocates the supervision resources better. However, as a coin has

two sides, there are disadvantages of a single regulator: ○1 A single regulator lacks

the mechanisms to inspect supervision loopholes. A single regulator would neglect

certain financial risks or some systemic important financial institutions’ risk status.

Without effective supervision make up, it may lead to serious consequences; ○2

There could be internal communication disorders in the single regulator. In Shanghai

FTZ, to facilitate management, a single regulator still would be divided into many

functional departments to be in charge of different financial areas. That would

contribute to obstacles in information communication; ○3 The power of single

regulator is too concentrated and lacks restraint, which may lead to decrease the

supervision efficiency. Through the above analysis, applying a single regulator in

Shanghai FTZ is the better choice. To overcome its disadvantages, macro prudential

supervision, better inside communication and more restrains shall be applied.

3.2. Supervision on Offshore Financial Business

China’s offshore financial market starts late, and its development is also gone through

twists and turns. In May, 1989, the People's Bank of China allowed China Merchants

Bank to run offshore banking business in Shenzhen. Subsequently, a number of banks

got approval, such as Shenzhen Development Bank, Guangdong Development Bank

Shenzhen branch, ICBC Shenzhen branch and Agricultural Bank of China Shenzhen

branch. Qualified banks got approval in Shanghai to begin offshore financial business.

Due to the Southeast Asia financial crisis in the beginning of 1999, the People's Bank

of China and the State Administration of Foreign Exchange had suspended all

offshore financial business of domestic banks. Until June, 2002, China Merchants

Bank and Shenzhen Development Bank were approved by the People's Bank of China

to start offering offshore business in Shenzhen, and Bank of Communications and

Shanghai Pudong Development Bank were allowed to run offshore financial business

in Shanghai. At present, limited offshore financial business is allowed, and the scale

of offshore financial business lags behind of that of western countries.

3.2.1. Current Status and limits of Offshore Banking Business in China

So far, regulatory on China’s offshore financial market still has obvious flaw, and has

not formed a complete supervision system. Firstly, the supervision legislation is still at

a lower level. The relevant regulations or administrative measures are as following,

Regulations of Offshore Banking Business, Detailed Rules for the Implementation of

Regulation of Offshore Banking Business, Measures of China Banking Regulatory

Commission for the Implementation of Administrative Licensing Matters Concerning

Chinese-funded Commercial Banks, Measures of China Banking Regulatory

Commission for the Implementation of Administrative Licensing Matters Concerning

Cooperative Financial Institutions, Procedures on the Administration of Borrowing of

International Commercial Loans by Institutions within Chinese Territory, Regulation

of the People's Republic of China on the Administration of Foreign-funded Banks.

However, the framework of offshore banking business is initially established.

Secondly, the regulating function of the authority is limited. Even, there are

contradictions between the supervision policies. The jurisdiction on offshore banking

business is distributed in the above regulations or administrative measures. State

Administration of Exchange Control is authorized by Regulations of Offshore

Banking Business to regulate the offshore banking business. However, its jurisdiction

is limited in regulating foreign exchange business, which means that Administration

of Exchange Control can’t regulate the offshore banking business effectively.

3.2.2. Offshore Banking Business Supervision in Shanghai FTZ

In order to establish offshore financial market, Shanghai FTZ firstly needs to

determine the specific offshore banking business model. In comparison, and the

internal and external separation offshore financial model is more suitable for

Shanghai FTZ. This kind of offshore banking business is derived by the government,

and established specifically for non-residents. The internal and external separation

offshore financial model is in accordance with the orderly conduct of offshore

financial business in Shanghai FTZ under the guidance of the government. Secondly,

one of the important reasons for choosing the internal and external separation offshore

financial model is the issue of hot money. In view of foreign offshore financial centers’

experience, suddenly turning of short-term capital flows is one of the important

causes of the crisis in financial markets. Due to the freedom of trade in Shanghai FTZ,

it is easy for hot money to find spaces; in addition to the unsound financial

supervision, there are many blanks, which could be used by hot money. It is

foreseeable that hot money would try best to maximize their profit. How to prevent

hot money banging the market, and affecting the normal economic order becomes the

focus of offshore financial supervision in Shanghai FTZ. One the most important

advantages of the internal and external separation offshore financial model is that it

separates the internal and external market, which helps in effectively stabling the

exchange and the financial market. Besides, the internal and external separation

offshore financial model has low requirements in financial liberalization and financial

supervision system, and its impact on the domestic economy can be controlled in a

limited range. Taking the current status of China’s financial supervision into

consideration, internal and external separation model suits the Shanghai FTZ. If the

permeability model was implemented in Shanghai FTZ, because of the high amount

of foreign exchange reserve and the increasing appreciation pressure on RMB, it

would bring huge risks for real economy. Therefore, the internal and external

separation model suits Shanghai FTZ most.

As to the offshore financial market access supervision, it can be generally divided into

market access supervision subject and scope. About the market access standards,

national treatment should be strictly carried out in Shanghai FTZ, according to WTO/

GATS requirements. It is not only the demand of developing offshore banking

business, but also the common practice for most countries; as to market access scope,

for better attracting investment, more wide standards should be drawn up in Shanghai

FTZ, to allow the entrance of banks and non-bank financial institutions. Supervision

of offshore banking business can be divided into capital supervision, business scope

supervision and transaction currency supervision. According to the common practice,

capital supervision always takes the method of indirect control; as for the scope

regulation, there are three situations, namely limited in traditional banking business,

extended to the bonds and notes business and traditional banking and other

comprehensive financial services business (Luo, 2008). One of the aims to establish

Shanghai FTA offshore market is to raise sufficient capital for development, but it also

needs to pay attention to the prevention of financial risks. Therefore, in the scope of

business regulation, regulation on business scope should include traditional bank

business and securities business; for the transaction currency, under the background of

financial reform in Shanghai FTZ, it should gradually promote the convertibility of

RMB capital account. The prosperity of offshore market could be hardly achieved

without RMB’s prosperity trading. For the offshore financial tax system in Shanghai

FTZ, preferential tax system is generally choice of offshore financial center. However,

the actual choice of preferential tax system should be in accord with the Shanghai

FTA. For instance, as the main purpose of the offshore center of America is for dollar

reflux, it determines that US doesn’t provide many tax preferential. In order to

strengthen the competitiveness and raise funds sufficiently, preferential tax is essential.

But in the current stage, only rely on the super national treatment preferential taxation

can't attract enough capital, but better integrated environment. Therefore, it is

appropriate to implement moderate tax in Shanghai FTZ.

3.3. Regulation on Interest Rate Marketization

The real interest rate marketization is to let the market mechanism play a decisive role

in forming capital price, thus guiding the rational flow of funds and improving the

efficiency of capital allocation. However, the interest rate marketization is not equal to

be without supervision, on the contrary, the stability of interest rate market in

Shanghai FTZ depends on the effective financial supervision. Experience abroad

show that the effective supervision mechanism could ease the short term impact

brought by market-oriented reform of interest rate, and ensure the normal

development of the market-oriented reform.

3.3.1. Current Status and limits of Interest Rate Marketization In China

At present, measures of financial regulation in China is relatively single, mainly

depend on the regularity supervision, namely through a system of laws and

regulations to regulate related financial activities in the market. And so is the interest

rate regulation. Under the separate supervision system, people's bank of China, China

banking regulatory commission, China securities regulatory commission and China

insurance regulatory commission are established to be in charge of the financial

regulation. However, it lacks of macro prudential regulation and pays less attention on

systematic risks66

. This is decided by the specific structure and developing stage of

China’s financial sector. Also the main source of financial risk is not systemic risk.

However, as the financial supervision practice during the interest rate marketization

process shows, western countries are more and more depent on the integrated

application of administrative, legal, economic and other measures. While, under the

current regualtion mode, complicance supervision is mainly adopted, which brings

more administrative interference, causing casualness in actual fiancial suoervision,

which leads to lacking bound, lacking risk supervision and ineffective supervision.

Under the interest rate marketization process in Shanghai FTZ, simple compliance

supervision can hardly meet the demands of Shanghai FTZ. ○1 As it depends on

strict financial regulations, compliance supervision doesn't have enough consideration

of new situations during reform, which could damage financial innovation and

banking effieciency in Shaghai FTZ. ○2 The formulation and implementation of

financial laws and regulations often lags behind the actual situation, lacks market

sensitivity and can’t reflect the risk situation that commercial banks face. ○3

Compliance supervision focuses on disposing afterwards, which couldn’t play the role

as risk early warning.

66Zhang Xiaopu, Lu Zhao. Choice of financial supervision system: international comparison, well principles and reference [J]. Studies of International Finance, 2012 (9): 79-87.

3.3.2. Supervision on Interest Rate Marketization in Shanghai FTZ

In view of the reform task of Shanghai FTA, the marketization of interest rate must go

ahead, and has already stepped into the most crucial phase. As practice has proved,

because of improper operation in the deep-water district, many countries’ interest

rates marketization eventually fail, even leading to a serious banking crisis. The

interest rate marketization process would not be always smooth. Only proper

supervision could ensure the smooth progress of interest rate marketization. For

example, interest rate marketization reform of Japan is derived by the government,

and also is gradual reform. However, when facing a banking crisis in the later reform,

more mergers, assistance and full faith and credit are applied to save the banking

sector, leading the Japanese economy into a long-term downturn in a certain extent.

For the reason that there are great differences between China and the western,

supervision on interest rate marketization has to be explored to be in line with the

actual situation of Shanghai FTZ.

First of all, sound and effective supervision system needs to be established in

Shanghai FTZ, completing both micro and macro prudential supervision, regulation

on interest rate related risks, and regulatory mechanism reform. A sound framework of

macro prudential management shall be established to strengthen the supervision

coordination between agencies. Also, contra-cyclical measures should be utilized to

maintain financial stability in Shanghai FTZ. Regional banking monitoring and

management system should be established to focuses on symmetric risk and

systemically important financial institutions.

Secondly, supervisory work in Shnaghai FTZ should focus on the establishment of

deposit insurance system, guarding against and defusing systemic risk caused by the

failure of single banking institution, enhancing the ability against systemic risks, and

solving the problem of "too big to fail". Interest rate marketization in Shanghai FTZ

would weak the bank profitability, leading capital to risky assets, coupled with the

interest rate risk, systemic risk is easy to be accumulated, causing banking industry

crisis. From the practical experience of many countries, the deposit insurance system

could guard against systemic risk effectively. It can not only restrain moral hazard

problem of the banking industry, but also help stabilize the financial system and

prevent risk splice after failure of financial institutions. In the process of the interest

rate liberalization, developed countries all established deposit insurance system. For

example, during the second interset rate liberalization process in 1996, South Korea

set up the deposit insurance system, and successfully reduced banking moral hazard,

easing the impact of economic marketization, guaranteeing the success of interest rate

marketization reform. However, how to build deposit insurance system, how to

establish the insurance institution in Shanghai FTZ has yet be determined. It still

needs to be explored in practice.

Finally, but not least, the existing investigation on site shall be improved to monitor

the banking interest rate volatility. More sepecificly, regular monitoring system on

banking interest rate fluctuation should be established. Also, supervision system on

liquidity risks needs to be eatablished, namely the liquidity risksupervision indexes

system, which cores are Liquidity Coverage Ratio and Net Stable Funding Ratio.

Adhere to regulate capital adequacy ratio of commercial banks inShanghai FTZ,

strictly regulate the liability composition, maintain high liquidity ratio, supervision on

interest sensitive assets and interest rate sensitive liabilities. These two above

indicators, Liquidity Coverage Ratio and Net Stable Funding Ratio, are to supervise

commercial banks to deal with the velocity shockliquidity. Liquidity coverage ratio is

to ensure that banks maintain adequate quality assets to response to short-term (30

days) the major risk impact, while net stable funding ratio is to deal with long-term

risk flow for banks, encouraging banks to adjust the structure of assets and liabilities

to reduce short-term financing maturity mismatch, and promote their assets and

liabilities structure reasonable67

.

3.4. Supervision on Capital Account Liberalization

In the process of internationalization of the RMB, capital account liberalization is

indispensable. For China, without proper supervision, it is hard to imagine effective

capital account open. In practice, because of capital account open, many countries

suffer a lot from the crisis caused by improper capital account liberalization. In the

process of capital account open of Shanghai FTZ, appropriate monitoring mechanism

needs to be established to ensure secure and stable operation of the economy.

3.4.1. Current Status of Supervision on Capital Account Liberalization

In accordance with the IMF’s "Annual Report on Exchange Arrangements and

Exchange Restrictions 2011", capital account control can be divided into capital and

money market instruments transaction control, derivatives and other tools transaction

control, credit instruments transaction control, investment control, direct investment

control, estate transactions and personal capital transaction control. According to this

standard, there are 22 items of part convertible account, 14 items of basic convertible

account and 4 items of inconvertibility account. Details are as table 3.1 below.

Table 3.1 statistical table of capital account control items

item total

inconvertibilit

y

part

convertible

basic

convertible

capital and money market

instruments transaction

control 16 2 10 4

derivatives and other 4 2 2

67 Ba Shusong, Zhu Yuanqian. A review of the Basel Capital Accord Ⅲ [M]. China Financial Publishing House. 2011..

tools transaction control

credit instruments

transaction control 6

1 5

investment control 2

1 1

direct investment control 1

1

real estate transactions

control 3

2 1

personal capital

transaction control 8

6 2

total 40 4 22 14

Source：People’s Bank of China. Speed up opening capital account in China [J].

China Finance, 2012, (5).

As to securities investing, China implements the qualified foreign institutional

investor (QFII) system and the qualified domestic institutional investor (QDII) system.

The QFII system allows foreign investors through the strictly regulated special

account to invest Chinese securities market. Under QFII, its capital, capital gains,

dividends could be remitted after approval. The QDII system, reverse system of QFII,

allows qualified domestic institutions under regulatory approval, in the certain extent,

to invest in foreign securities markets through special account68

.

3.4.2. Supervision on Capital Account Liberalization in Shanghai FTZ

According to Opinions of the People's Bank of China on Financial Supporting China

(Shanghai) Pilot Free Trade Zone, there would be no longer QFII, RQFII. Enterprises

in Shanghai FTZ would invest in securities and futures. Individuals could directly

invest in overseas securities market without QDII constraints. The institutions, which

provide financial services to entities in Shanghai FTZ, is not limited in the zone, but

in Shanghai. With deepening financial openness, effective financial supervision

system in Shanghai FTZ is in urgent need, to prevent risks from capital account

liberalization.

Firstly, statistical monitoring system shall be established and perfected, and makes

early warning on abnormal capital flow. The macro prudential supervision framework

shall be established and perfected, utilizing the macro prudential tools to compensate

the limitations of other macroeconomic policies. These macro prudential tools include

capital adequacy ratio, provisioning rate, leverage and liquidity indicators. However,

due to the different situation from that of western, how to utilize these indicators in

practice still needs to be continuously explored.

Secondly, information disclosure system should be strengthened to stable investor

68 Capital account management ， People’s Bank of China, Tianjin Branch. More Details ：

http://tianjin.pbc.gov.cn/publish/fzh_tianjin/2909/2011/20110830145932274439248/20110830145932274439248_.html

confidence. To a certain extent, investor confidence contributes to the volatility of the

market fluctuation. At present, China's information disclosure system is fragmented,

scattered in the "Interim Measures for the Information Disclosure of Commercial

Banks", " Accounting Law of the People's Republic of China", " Measures for the

Management of Capital Adequacy Ratios of Commercial Banks" and other laws and

regulations. A unified information disclosure system should be established as soon as

possible, to strengthen the transparency of the market.

Thirdly, it is necessary to strengthen the capital flow management measures (CFMS),

and impose temporary capital controls in case of emergency. For instance, financial

trading tax could be flexibly imposed, to constrain on the scale and period of capital

inflow. Even it could ban abnormal capital into a certain field, to ease the volatility of

short-term capital flow. Financial transaction tax, based on specific purpose, imposes

on transactions of specific financial products, such as stock, bonds, derivatives and

foreign exchange tool69

. The main role is to alleviate the short-term volatility caused

by large-scale flow of capital. According to the Brazil’s successful capital account

openness experience, it could impose different tax rates based on the period of foreign

loans. The shorter period, the higher tax rates are, however it would impose tax on

foreign loans more a certain period of time (such as 5 years). During a crisis, when

capital outflow happens, it could gradually reduced tax rate until the abolition of taxes

on financial transactions; while facing a large number of short-term fund inflow, it

could be gradually raised tax rate on all kinds of financial transaction, such as FDI,

various types of securities and funds, foreign loans, and derivative product

transactions, to prevent capital from avoiding controls.

4. Conclusions and Recommendations

Market economy is legal economy, and financial regulation in Shanghai FTA needs to

follow the rules of market economy. On one hand, the demand of legality is decided

by the nature of the market economy. Without regulatory, the effective operation of

the financial market in Shanghai FTA is unimaginable. On the other hand, the

development and perfection of financial supervision also depends on the development

of financial market. The strict enforcement of the law is the key to realize the

effective supervision in Shanghai FTZ. The legislation of the financial supervision is

particularly important in the financial supervision in Shanghai FTA, properly handling

the relationship between financial supervision and the market is by financial

supervision has important meaning. However, in fact, the choice of the supervision

model should also consider the influence of interest groups, and reflect the need of

financial legislation of virtual economy.

4.1. Improve Financial Supervision System, Strengthen Macro Prudential

Supervision

69 He Ziqiang. Financial trading tax under post financial crisis: debate, practice and reference [J]. Shanghai Finance, 2011,10: 007.

At present, financial supervision legislation in Shanghai FTZ still has many blanks,

and unified financial legal system has not yet formed. Therefore, it is necessary to

formulate a unified financial supervision system, which would lay a solid foundation

for further development Shanghai FTZ and also provide valuable experience for latter

financial reform in China. On constructing process of FTZ, financial supervision

legislation also need to constantly adapt to the needs of the development of virtual

economy.

Macro prudential regulation should be base of supervision in Shanghai FTZ, to

prevent systemic financial risk. A single supervisory mechanism under the

comprehensive supervision meets the actual needs of Shanghai FTZ. Through

legislation to clear a single authority’s regulating scope and responsibility, give

regulator enough to rights to take preventive or remedial measures, improving the

effectiveness of financial supervision. Single regulation can reduce the regulation cost;

achieve economies of scale; adapt to the trend of integration in the financial

institutions; avoid the supervision vacuum and other issues, and better coordinate

financial supervision and the development of financial services in Shanghai FTZ.

4.2. Improve the Supervision on Offshore Financial Business

Offshore financial market in Shanghai FTA should be internal and external separation

model, independent of the current account management system and monitoring capital

flows of all accounts. First of all, internal and external separation model is suitable for

the offshore financial markets, which are driven by the nation. Secondly, because of

the issue of hot money, huge foreign exchange reserves, permeability model may

bring huge risk to China. Upon the market access supervision, according to the rules

of WTO/GATS, national treatment should be carried out, allowing banks and

non-bank institutions into the offshore market. As to the regulation of business types,

indirect control is more suitable. Based on to the actual requirements of international

financing and risk prevention, traditional banking and securities business shall be

permit in Shanghai FTZ. As for the offshore financial supervision, effective macro

prudential supervision framework should be adopted in Shanghai FTZ, including

capital adequacy, credit risk, liquidity risk, internal control system and other risk

index.

4.3. Improve Regulation During the Marketization of Interest Rate

Superimposed on the interest rate market is the supervision of risks of the

marketization of interest rates and risk. In the process of interest rate marketization, a

sound and effective supervision system must be established in Shanghai FTZ,

including the micro prudential and macro prudential measures, focusing on regulation

of liquidity risk. To solve too big to fail, deposit insurance system also shall be

constructed in the banking sector, focusing on systemically important financial

institutions, to prevent and resolve the systemic risk caused by failure of single

banking institution. Secondly, the regular monitoring system shall be improved to

regulate banking interest rate fluctuations, mainly by the liquidity coverage ratio and

net stable funding ratio. Adhering to keep high bank capital adequacy, regulate the

structure of assets and liabilities and maintain high liquidity ratio would keep the

banking sector in Shanghai FTZ stable.

4.4. Improve Capital Account Regulation in Shanghai FTZ

First of all, to cope with the new financial risks along with the opening of the capital

account, macro prudential regulatory framework, including statistical capital adequacy,

provisioning rate, leverage and liquidity indicators, monitoring abnormal capital flow,

shall be established in Shanghai FTZ. Secondly, establishing and improving the

information disclosure system. Thirdly, in emergencies, capital flow management

measures (CFMS) should be adopted, such as the financial transactions tax, limiting

the capital flows to alleviate the volatility of short-term capital caused by mass flow.