China’s bold makeover of its capital markets a step in the right direction

Proposals include allowing banks to underwrite securities, consolidating the fragmented brokerage sector, and letting insurers trade in T-bond futures – a sign that Beijing is turbocharging its financial reforms

Joel A. Gallo

Published: 8:00pm, 19 Jul 2020

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At a time of unprecedented geopolitical uncertainty, punctuated by the Sino-American trade war, China has unveiled bold initiatives to modernise its financial sector. Historically, the modernisation playbook consisted of, first, reform to enhance the competitive standing of firms and capture synergies across market segments, then an epoch of openness to attract foreign participation in capital markets.

Although the Wealth Management Connect programme to forge closer economic ties in the Greater Bay Area has been garnering attention, a bolder and much-needed makeover is imminent in China’s banking, brokerage and insurance sectors.

The China Securities Regulatory Commission is mulling a pilot programme to award securities licences to state-owned commercial banks. If granted, Industrial and Commercial Bank of China, reportedly one of two banks being considered for the pilot, stands to conduct securities underwriting and certain brokerage services. This is a boon for commercial banks, which have been operating under China’s version of the Glass-Steagall Act that separates commercial from investment banking.

In the United States, critics have argued that abolishing this Great Depression-era legislation in 1999 paved the way for the creation of banks “too big to fail”. China, cognisant of the risks, is treading cautiously.

The ICBC building in Shenzhen is seen in March 2019. The China Securities Regulatory Commission is reportedly mulling a pilot programme to award securities licences to two state-owned commercial banks, including ICBC. Photo: Roy Issa

A more pressing concern is the woefully fragmented brokerage sector, with 131 firms having a combined asset size equal to Goldman Sachs’. The industry is plagued with inefficiencies – averaging 6 per cent return on equity, about half of Wall Street’s – and ripe for consolidation.

In a move that’s possibly a harbinger of mergers and acquisitions activity in the sector, officials are reportedly considering a proposal to merge the top two firms in the space, Citic Securities and CSC Financial. If consummated, the deal creates a road map for other corporate marriages as domestic firms steel themselves for the opening of the securities industry to foreign competition.

Don’t make China out to be the economic bogeyman

Compared to their massive commercial banking cousins, securities firms are minor role players and their services have been limited to mostly trading and securities underwriting. Creating through consolidation heavyweight contenders with expanded balance sheets opens up possibilities of more capital-intensive activities, including market making, margin financing and securities lending.

As a wider array of services are developed, greater opportunities for cross-selling both capital-intensive and capital-light products, such as client fundraising and mergers and acquisitions advisory, become more straightforward.

Not to be outdone, the insurance sector, long considered a sleepy segment of the financial industry, also made a recent news splash by obtaining clearance to trade in Treasury bond futures, but as a hedging vehicle only. Unlike their European and North American counterparts, Chinese insurance companies do not employ a wide spectrum of derivative instruments to manage risk. Lack of product diversity constrains an executive’s ability to manage the interest rate risk of bond assets and to control the mismatch between assets and liabilities on the maturity horizon.

Allowing insurers to trade bond derivatives brings much-needed participants that yield a positive residual effect for capital markets. Over time, insurance companies and other institutional players trading in T-bond futures and other instruments enhance pricing accuracy and increase liquidity, providing that much sought-after breadth and depth found in mature capital markets.

Why are these proposals surfacing now? China aspires to build aircraft carrier-sized brokerages that can compete head-to-head in the local (and gradually global) marketplace with the likes of Goldman Sachs or Morgan Stanley. Size matters, as evidenced by industry league tables that break down global investment banking and deal-making activity into component parts – all of which are dominated by the titans of American and European investment banking.

More crucial is the expectation for the securities industry (and the broader capital markets) to step up and help the economy expand, where, before, the heavy lifting was performed by an overburdened commercial banking sector.

While the big four commercial banks as a group are first-class, China needs a complementary dynamic capital market to spur economic growth. The innovative proposals for banking, brokerage and insurance sector reform that harness the dynamics of its fast-growing financial marketplace signal that Beijing is turbocharging efforts to modernise the whole financial industry.

Joel A. Gallo is CEO of Columbia China League Business Advisory Co

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