EMERGING INSTITUTIONAL INVESTORS rNCHINA OCTOBER 2 W EAST ASIA AND PACIFIC REGION THEWORLD BANK B ABBREVIATIONS AIG American International Group, Inc. ABS Asset-Backed Securities AMCs Asset Management Companies BOC Bank of China BOCI Bank of China International CCB China Construction Bank CD Certificate of Deposit CIFs Collective Investment Funds CIRC China Insurance Regulatory Commission CITIC China International Trust and Investment Corporation CP Commercial Paper CSRC China Securities Regulatory Commission EU European Union FEFSI Federation Europeene des Fonds et Societes d'Investissement (European Federation of Investment Funds and Companies) GDP Gross Domestic Product IPOs Initial Public Offerings JV Joint Venture Ltd. Limited M&As Mergers and Acquisitions MMF Money Market Fund MOF Ministry of Finance MOLSS Ministry of Labor and Social Security NASD National Association of Securities Dealers NBFI Non-Bank Financial Institution . NPC National People's Congress NSSF National Social Security Fund OECD Organization for Economic Cooperation and Development PAYG Pay-as-You-Go PBOC People's Bank of China PRC People's Republic of China QFII Qualifying Foreign Institutional Investors Repo Repurchase Agreement RMB Renminbi (Chinese currency: Yuan) SAFE State Administration of Foreign Exchange SOE State -Owned Enterprises TICS Trust and Investment Companies us United States UK United Kingdom WTO World Trade Organization Table of Contents EXECUTIVE SUMMARY ...............................................................................................I 1 INTRODUCTION ...............................................................................................1 2 THE ROLE OF INSTITUTIONAL INVESTORS IN CAPITAL M R K E T DEVELOPMENT ........................................................................................................2 3 TODAY'SINSTITUTIONAL LANDSCAPE.......................................................4 Overview .............................................................................................................4 Banks...................................................................................................................4 Pension Funds ..................................................................................................... 6 Insurance Companies ........................................................................................ 12 Collective Investment Funds............................................................................. 16 Securities Companies........................................................................................21 Trust and Investment Companies...................................................................... 23 Underground Funds .......................................................................................... 27 Summary of the Institutional Landscape and International Comparison.......... 28 4 CHANGES IN THE INSTITUTIONAL ASSET M N AGEMENT SCENE ........29 5 THE WAYFOR WARD......................................................................................36 Consolidation of Asset Management and Applicable Standards ......................37 Level Playing Field ........................................................................................... 40 Availability of Wider Range of Investment Opportunities and Products......... 42 Relaxation of Investment Restrictions ..............................................................44 Increased Role of Banks ................................................................................... 50 Pension Reform................................................................................................. 53 6 CONCLUSION..................................................................................................54 REFERENCES ..........................................................................................................60 EXECUTIVE SUMMARY This report describes the existing structure and activities of institutional investors in China. It identifies key principles for building a solid institutional investor base going forward. ' The nation's institutional investors are largely comprised of life insurance companiesand pension- and investment-fundmanagers. In addition, trust and investment companies (TICS) and securities companies offer their clients discretionary asset management services. Overall, China's ratio of institutionally-managed assets is small comparedto developed markets, representingaround 11percent of GDP. The life insurance industry is the largest repository of savings outside banking, and is enjoying strong growth in premium income. At present, life insurance companies are limited mainly to investing in government bonds and bank deposits, but may obtain CIRC permission to invest in other instruments, e.g., privately placed infrastructure bonds. The pension system entails a pay-as-you-go (PAYG) first tier, individual defined contribution accounts as a second tier, and a voluntary contribution. In some regions, individual accounts are used to cover shortfalls in the PAYG first tier. Overall, the prospects for significant accumulations in the individual accounts are limited; the odds are better that the voluntary schemes could eventually accumulate sizeable reserves. In addition, the National Social Security Fund (NSSF) could become a major capital market investor once a means is discovered for funding the establishmentof reserves. Closed-end and open-ended investment funds, both offered by fund management companies, are still in their infancy. Closed-end funds used to dominate, since they have been around longer, but open-ended funds, despite their short history, hold high growth potential. Domestic fund management companies have reportedly been prone to irregularities,includingcollusion and share-price manipulation. IThis report-written by Yongbeom Kim (Senior Financial Economist, East Asia and Pacific Region, the World Bank) and Mark St Giles (international consultant, Cadogan Financiabis an abbreviated and updated version of an earlier report titled, "Developing Institutional Investors in the People's Republic of China." The main thrust of the earlier report was presented at an international seminar on "Promoting Institutional Investors in China," held on April 1,2003, in Beijing. Irene S. M. Ho contributed substantively to the earlier report, while research assistance for this version was provided by Yiping Zhang. The earlier version benefited from valuable comments from David Scott, Dimitri Vittas, Jun Wang, and Xiaoqing Yu. Meanwhile, the findings, interpretations, and conclusions expressed in this paper are entirely those of the authors, They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Securities companies and TICS offer discretionary management services for 1 portfolios of large investors, i.e., mainly for large state-owned enterprises (SOEs). Guaranteed returns are often offered, largely for investments in the equity market. But the market downturn since mid-2001has impaired the ability of securities companies and TICs to honor the promised guaranteed returns for investors. The collapse of many large TICs in recent years revealed many abusive and imprudent practices. Commercial banks play a limited role in distribution, mainly conducting as-agent sales of mutual funds and life insurance. They are prohibited from engaging in securities and insurance activities as principals, although some banks have been able to circumvent these restrictions through affiliated firms. China has the potential to build one of the largest institutional investor bases worldwide. Promoting the emergence of competent institutional investors is an important complement to an overall capital markets development strategy. Since institutional investors tend to have longer-term investment time horizons, they provide an ideal source of funds for investment in longer-term government and infrastructure bonds. Moreover, institutional investors would add depth and liquidity to the equity markets. Tapping into this demand will improve prospects for the market to better absorb increased equity supply resulting from the sale of state shares. Institutional investors would increase pressure on firms, listed and otherwise, to adopt better corporate governance structures and practices. The benefits cited above can be achieved through a general strategy to build well- capitalized, creditworthy and efficient investment management institutions in China. This would involve steps to substantially improve the corporate governance of all financial institutions offering investment management services and to strengthen their institutional capacity. The latter would include ensuring that proper internal controls and internal audit functions, risk management systems, management information systems and an external audit function are all in place and functioning appropriately. It also would involve ensuring that the managers and employees of investment institutions have adequate professional skills and that they are subject to a system of controls and incentives that promotes prudent behavior and acting in the clients' best interest. For the purpose of efficiency, simplicity and fairness (ensuring a level playing field), common standards would be applied to all investment management institutions that manage discretionary investments of others, including insurance companies, pension funds, investment fund managers, TICs and securities companies. A thorough and coordinated review of existing regulations would be sought with the aim of upgrading them where deficient, and to harmonize them for all classes of investment management institutions. Similarly, action would be taken to harmonize the professional qualification requirements of employees who advise clients or make investment decisions on their behalf. The necessary professional skills involve investment analysis and portfolio management. Efforts to strengthen the governance and institutional capacity of investment management institutions are not likely to be sufficiently successful as long as those institutions remain under government ownership, as almost all are today. Only a few examples exist internationally of successfill government-run investment management institutions, and these have occurred under social and economic conditions very different from those in China. Thus, the factors integral to building a substantial professional institutional investor base are ownership diversification and privatization of existing institutional investors; promotion of new entry, including foreign participation; and creation of a level playing field for all institutional investors, regardless of ownership. To this end, particular emphasis would be given over the next few years to increasing foreign participation in the institutional investor market. The goal would be to transplant a critical mass of technology and skills sufficient to rapidly and markedly upgrade the capacity of institutional investors in China, and to rapidly train a new cadre of Chinese investment professionals to lay the foundations for a strong domestic segment of the institutional investor industry. In addition to these general strategies and actions, steps would be taken to encourage increased securities demand by institutional investors. Fixed-income mutual funds would be promoted as a means of increasing demand for longer-term government bonds. The proposed strategy essentially is to promote the emergence of new classes of mutual funds that would appeal to the growing demand of investors having less risk appetite and/or longer investment time horizons. Liberalization of interest rates in the primary government debt market would be an essential prerequisite. To create demand for infrastructure bonds, action would be taken to relax investment restrictions currently applied to different types of institutional investors. China currently permits investment managers to invest only in those types of products explicitly listed, thus restricting institutional investors' ability to craft diverse and balanced portfolios. Further, the permitted investments are often limited, in comparison to international practices. A thorough and comprehensive review would be sought, with the goal of rationalizing, harmonizing and liberalizing the investment restrictions currently in place. In particular, investments in long-term infrastructure bonds meeting defined information disclosure standards and risk characteristics would be permitted for all classes of institutional investor. A complement to expanding the range of permissible investments would be to improve regulatory requirements on disclosure of risks and probable returns. To create greater investment demand for equities, actions would be taken to strengthen the professional capacity of institutional investors to manage equity portfolios with a longer-term investment horizon. Of particular relevance are life insurance companies and pension funds. Once appropriate institutional capacity is in place, investment restrictions applicable to institutional investors would be further relaxed to permit investment in equity securities. Complementary actions would be taken to promote greater foreign portfolio investment, whether under the new QFII regime or otherwise. Tapping into demand for Chinese securities by international investors would be leveraged both to increase the absorptive capacity of the capital markets for a wide range on instruments and to create an independent source of pressure for improved instrument design and pricing, better corporate governance, and improved infrastructure project design. 1 INTRODUCTION 1. China needs to develop solid long- national, strategic objectives, resulting in a term investment institutions, which can be highly polarized deployment of savings by broadly categorized as pension funds, life- the population. insurance companies and collective investment funds. 7. The more risk-averse individuals prefer to keep savings with institutions that 2. These types of institutions currently they recognize and trust (largely banks, the exist in China, but they are at a nascent stage government, and to some extent life- of development and would benefit from insurance companies) despite falling yields more clearly defined plans for their future resulting from a progressive reduction in development. interest rates; real returns on offer are now very low by international standards. At the 3. China's capital markets and other end of the spectrum, those prepared to investment sectors have been growing accept risk gamble in the equity markets. swiftly, but at the cost of being developed There is little on offer between these two ahead of the strategic, legislative and extremes. regulatory framework. 8. Currently, Chinese households 4. The resulting institutional landscape deposit 75 percent of their savings into is characterized by blurred boundaries banks, with only 4 percent invested in the among the different institutions and their insurance-and-pensionsector. In contrast, in activities; an insufficient legal base; varied the US, the insurance-and-pension sector (and sometimes competing) regulatory holds the biggest share with 30 percent, agencies; and jurisdictional uncertainties while currency and deposits account for only among institutions. 15 percent. Japan's case, in a sense, looks somewhat similar to China's, but Japan has 5. The rigid and restrictive structure a solid insurance-and-pension sector that placed on institutional investors along with attracts more than 25 percent of household unclear direction resulted in the emergence savings. of so-called underground funds-informal, semi-legal structures designed to let larger 9. To have a balanced financial system, investors seek semi-professional managers household savings ought to be well spread for their portfolios. across banking and non-bankingproducts, as in the US. Thus the medium-term objective 6. There are few well-recognized and for China would be to increase its non-bank trusted non-bank financial institutions sector, especially its institutional investors (NBFIs) among the institutional investors. sector, to a level on par with Japan's. This has discouraged the vast pool of domestic household savings from being 10. To reach these goals, this paper notes constructively mobilized to meet key the existing structure and the activities of institutional investors in China and provides - Household deposits stood at RMB 8.04 trillion, or some principles on how to build a solid US$ 971 billion (1 US$ = 8.28 Yuan), which is 83.8 institutional investor base going forward. percent of GDP at end-May 2002, while the total balance of all deposits amounted to RMB 15.33 trillion (160 percent of GDP). 11. Specifically, this paper reviews the the implications of financial sector opening relationship between capital market and the emergence of financial development and institutional investors conglomerates (section 4); discusses (section 2); provides a brief overview of principles for successful development of China's financial landscape vis-a-vis institutional investors in China (section 5); institutional investors (section 3); focuses on and summarizes the conclusions and recent changes in the institutional asset recommendations (section 6). management scene, with special attention to 2 THE ROLE OF INSTITUTIONAL INVESTORS IN CAPITAL MARKET DEVELOPMENT 12. China has strong reasons to develop and equity. One of the most distinctive its capital markets. SOE sector reform, recent changes in financial markets is the banking system restructuring, and pension 'institutionalization of ~ a v i n ~ ' ~shift - - a away reform constitute key economic agendas for from individuals' holding equity directly the government, and successful toward intermediaries holding it5 The drop implementation of these three agendas will in individual holdings to a large degree has require robust capital markets. SOE reform, been replaced by the increased share of for example, will involve increased initial pension funds, life insurance companies, and public offerings and strong corporate collective investment funds. Among them, governance; and banking sector collective investment funds have recently restructuring will need efficient debt capital exhibited the most rapid growth in many markets to be developed. Further, China countries. For example, the recent intends to address its pension shortfalls comparative figures from the Organization through its sale of state shares, which in turn for Economic Cooperation and Development depends on the absorption capacity of its (OECD) show that collective investment capital markets. funds in OECD countries had an average annual growth rate of 20 percent in the years 13. To develop her capital markets, 1991-1998, compared to 13 percent for China needs, among other things, to foster pension funds and 11 percent for insurance 3 the institutional investors sector. companies. Institutional investors play an instrumental role in capital market development in the 15. Second, institutional investors act as following ways: catalysts for financial innovation by creating new products, improving accurate pricing of 14. First, they provide a means of financial assets, encouraging new market- channeling savings into the capital markets with medium- to long-term investment 4David and Steil (2001) provide a comprehensive horizons and with low-to-medium-risk to economic assessment of this important shift. Individual ownership of equity has fallen in the investors. They also provide absorption United States from 79 percent in 1966 to around 50 capacity for issues of public and private debt percent in 1993, while corresponding numbers in Japan were 53 percent in 1953 and about 20 percent 3 Major agendas include increasing the supply of in 1993 (Allen and Gale, 2001,p. 58-67). 6 quality shares; improving securities regulation; better Fernando et al. (2003) provides an excellent survey protecting investors' rights; enhancing market of the global growth of collective investment funds. integrity; and reforming corporate governance. OECD (2002). participant entry, and pursuing better institutional investors to the development of clearing and settlement. In the US, for capital markets. Specifically, this research example, institutional investors, especially usually shows that those countries with more pension funds, played a key role in developed institutional investors sectors are introducing such innovative products as also the counties with more advanced capital zero-coupon bonds, mortgage-backed markets, both in terms of market size and securities and financial derivatives since the value traded (e.g., Calatan, Impavido, and 1970s. Similarly, the development of Musalem, 2000). Impavido, Musalem, and money market funds (MMF) has contributed Tressel (2003) suggested that the to financial innovations in money markets, development of contractual savings notably CDs, CP, swaps, and repurchase institutions (pension funds and life insurance agreement (RP). Pressure from large companies) had a positive impact on the institutional investors to lower commission development of equity markets in countries charges for large trading volumes often led with a capital market-based financial system, to freeing up stock brokerage commissions while the development of the contractual and sparked even broader capital market savings sector contributed to the bond reform-eventual1 y resulting in the so-called market more in countries with a bank-based the "Big Bang" in the United States in the financial system. As a country case, the 1970s and in the United Kingdom in the Chilean pension scheme8, initially set up in 1980s. 1981, and the capital market development that followed is widely viewed as 16. Finally, institutional investors help exemplifying the positive interaction establish high standards for compliance, between them. disclosure and oversight of information (especially financial statements) and help 18. The close linkage between strong improve corporate governance of market institutional investors and capital market participants. Only large shareholders such development should not be seen as a "one- as institutional investors have sufficient way street," however. Instead, the incentives and abilities, including the relationship is interactive: capital market financial ability, to monitor and communicate with corporate management This innovative scheme was designed to replace the on a consistent basis. In the United States, state pay-as-you-go (PAYG) system that was among large public pension funds such as the the earliest in the world offering almost universal California Public Employees Retirement coverage (established in 1925, ten years before the Scheme (CalPERs) and the Teachers US scheme). Under Chile's privatized system, which is monitored and regulated by the government, Insurance and Annuity Association-College neither the worker nor the employer pays a social Retirement Equities Fund (TIAA-CREF) security tax to the state. Nor does the worker collect have played a prominent role in shareholder a government-funded pension. Instead, during his activism. The mode of intervention varies, working life, he has 10 percent of his wages and may include submission of shareholder automatically deposited by his employer each month in his own, individual account. The contribution is proposals to companies and directors; direct not taxed. His pension level is determined by the negotiation with corporate management; and amount of money he accumulates during the number publicly targeting corporations through the of years he is working. The steady growth of funds media (see Gillan and Starks, 2002). under management has not only achieved the primary purpose, to provide social security benefits for old age, sickness and unemployment, but has also had the 17. Cross-country empirical research effect of energizing the capital market. See also supports the importance of strong Holzmann (1997). structure can either stimulate or impede if things go wrong; meaning that the development of institutional investors, enabling legislation plays a major role in especially collective investment funds creating and sustaining investor confidence. (CIFs). As argued by Vittas (1998), pension The availability (or lack thereof) of suitable funds and life insurance companies could financial instruments is of major importance develop on their own even when capital as well, especially for money market funds markets are underdeveloped. They initially whose success depends largely on their easy could develop on the basis of non- access to the higher wholesale money marketable instruments such as loans, bank market instruments\ r~lir-ce: KPMG. 131. The QFII scheme is subject to' strict about positive changes in equity investment. qualification requirements and tight curbs on First and foremost, share prices started to early repatriation. In addition, overvaluation differentiate according to the quality of of stocks, price differences between tradable shares. QFIIs concentrate on blue chips and non-tradable shares, and weak corporate with high liquidity and good profitability. In governance in listed companies would lead the past, shares tended to move in the same to limited foreign portfolio investment to the direction regardless of their qualities. PRC capital markets over the short term. Second, there are signs that momentum However, the introduction of QFII program trading practices are slowly giving way to a will likely have a positive impact on the value-based long-term investment culture. development of PRC capital market over the Third, the importance of transparency and medium to long-term, and eventually on the disclosure, which remains high on QFIIs' method by which PRC listed companies investment criteria, started to permeate into handle corporate governance issues. senior executives and controlling shareholders alike. 132. Indeed, the increasing presence of the QFIIs in the A share market has brought Box 1: The Qualifying Foreign Institutional Investor Scheme 1 Eligible QFIIs. Fund managers, insurance companies, securities companies, and commercial banks who meet the following requirements: Fund managers: minimum 5 years operational experience; assets under management not less than US$10 billion in the last accounting year. Insurance companies: minimum 30 years operational experience; securities assets not less than US$ I billion in the last year; revenues exceeding US$1 billion. Securities companies: minimum 30 years operational experience; securities assets not less than US$l billion in the last year; revenues exceeding US$1 billion. Commercial banks: Securities assets not less than US$lO billion in the last year; total assets ranked among the world's top 100banks. Eligible instruments. Any of the following RMB-denominated financial instruments: (1) shares; (2) listed T-bonds; (3) listed convertible bonds and corporate bonds; (4) any other financial instruments approved by the CSRC. Investment limits. Investment by a single QFII in a single listed company must not exceed 10 percent of the total shares of that listed company; the total percentage of shares held by all QFIIs in a single listed company must not exceed 20 percent of the total shares of that listed company. In terms of investment amount, QFlIs must invest US$ 50 million to US$800 million each. Lock-in periods. In general, QFIIs must keep their capital within the PRC for at least one year. For closed-end funds, the mini~numperiod is three years. During the lock-in periods, the finds remitted into China by the QFIIs must be held by custodians in a special purpose RMB account. Custodian services: A custodian bank must have (i) a specific fund custody department; (ii) paid in capital of no less than RMB 8 billion; (iii) sufficient professionals familiar with custody; (iv) the ability to manage the entire assets of the fund safely; (v) qualifications to conduct foreign exchange and RMB business; and (vi) no material breach of foreign exchange regulations in the past three years. Approvals from PBOC, CSRC and SAFE are required for custodian status. 5 THE WAY FORWARD 133. As a nation, China has the good urgently develop new financin mechanisms fortune to have a surplus of savings. for infrastructure investments. Rfi Individual savers, however, have the misfortune of lacking a sufficient range of 137. A third priority objective is to suitable outlets for their savings. The strengthen the professional capacity of distortions of the market itself are partly to institutional investors to manage blame for this, given the authoritarian investments in equity securities with a control of interest rates and equity markets longer-term investment horizon and to dominated by issues of relatively create greater investment demand for unprofitable state-owned enterprises. For equities. Traditionally, the short-term these reasons, building a range of well investment style of PRC equity investors capitalized, honest and efficient investment contributed to market volatility and institutions in a rational and balanced way provoked abusive practices. Strengthening must be considered an important component professional management capacity will lay of China's long-term strategy for capital the foundation for tapping the potentially market and economic development. huge pent-up demand for equity investment in China. This cannot be achieved so long 134. More specifically, there are at least as small investors are not comfortable four priority objectives for developing placing their savings with equity issuers and institutional investors. market intermediaries. Tapping into this demand will also improve the prospects of 135. One priority objective is to increase an orderly disposal of state shares. demand for longer-term government bonds. This will expand the investor base for 138. The fourth priority objective is to government bonds beyond the state build a significant and independent commercial banks, who are the major constituency for improved disclosure, investors in that market segment to date and corporate governance and minority who are increasingly reluctant to assume the shareholder protection by equity-issuing interest rate risk associated with long-term firms. The actions of professional investments. The SCB's inability to take on institutional equity managers can be increased levels of interest rate risk presents leveraged as an important complement to an urgent challenge for government debt regulatory efforts in this regard. management by the MOF. 139. The policy options that follow 136. A second priority objective is to underlie the successful development of create demand for infrastructure bonds, by institutional investors elsewhere. In general, their nature longer-term instruments. There it appears that the existing structure of are substantial potential synergies, currently capital markets in China is not yet in line unrealized, between the strategy to develop with these principles, which may account in institutional investors and the strategy to 88Two key weaknesses of current infrastructure financing structures are that they are excessively dependent on bank loans; and that they involve excessive use of government guarantees and thus give rise to excessive contingent fiscal liabilities. part for the slow and uneven development of Many countries have made the mistake of institutional investors. believing that the management of a pension fund portfolio is so different from the Consolidation of Asset Management and management of any other type of portfolio Applicable Standards that it must be done by a company 140. The approach in China of specifically licensed to do only that, and "experiment first, regulate later" has resulted cannot be done by another licensed asset in a complex set of structures. Issuing management company. This has the effect regulations prior to passing laws is seen as of diffusing valuable professional talent, having the advantage of allowing markets which is, in any case, in short supply in the flexibility to develop without being China. bound by laws. The disadvantage, however, is exemplified by constant changes in 144. In more advanced economies, it is regulations. It is commonplace for becoming increasingly hard to categorize inconsistencies to exist among institutional non-bank activity among mutual funds, investor-related regulations issued by insurance and pensions. The mutual fund different regulators. model is increasingly used to express an individual participant's ultimate pension and 141. One agency should be the lead life insurance benefits. This contrasts with regulator for any activity that involves the guarantees given to participants by securities or management of portfolios of traditional life insurance products and securities, by whatever organization. The defined benefit pension schemes, where the concept of a lead regulator is well life insurance company or the plan sponsor understood in countries that do not have stand as guarantors between the participant consolidated supervision of the whole and market risk. Also, even in jurisdictions financial sector. It may be seen as where life insurance companies and banks regulation by function, rather than by are physically separate and separately institution. regulated, the linkages between banks and life insurance companies are close. Such 142. The necessary professional skills linkages are evidenced by i) cross- common to all institutional investors are ownership (common in Germany), ii) the investment analysis and portfolio two forming part of the same group, or iii) management. While the objectives and time an ultimate holding company or subsidiary horizons of a pension fund and a collective ownership. investment fund may be different, the techniques for portfolio management in a 145. Unit-linked life insurance uses way that meets the objectives of the premiums received to make a series of investors are the same for all portfolio contractual purchases of free-standing classes. mutual funds (often those managed by the life insurance company itself or its banking 143. While one can appreciate the need affiliate), or of a series of internally for different prudential standards to be managed funds (not legally constituted as applied to pension funds and insurance mutual funds but operated in almost the companies, particularly if there are same way). In either case, market risk is guarantees involved, it may be unnecessary transferred from the life company as to create a special breed of investment guarantor to the participant. The life managers to manage each type of portfolio. insurance company's role becomes increasingly that of asset manager, providing interest, etc.) that would be applied to only a minimal life insurance parcel (death external managers. Of course, once an benefit), which is often required for tax insurance company, or indeed a large reasons.89 pension fund with internal management, starts to manage segregated third party 146. Pension funds too are moving away portfolios, it will have to comply with all the from being guarantors of a lump sum or an regulations that apply to independent asset annuity upon retirement, and want to management companies. transfer market risks to pension plan participants. A fund that transfers market 148. In China the common standards risk is generically known as a dejned should apply to all asset management contribution scheme. The regular companies that manage investments of contractual payments made by the employer others at discretion-insurance companies, andlor the employee are invested in mutual- pension funds, investment fund managers, fund-type instruments or internal funds trust and investment companies and which are operated as quasi-mutual-funds, securities companies. not unlike life insurance companies. Such pension schemes are managed by life 149. For securities companies, there is a insurance companies, asset managers or long-running argument regarding whether specially constituted structures. There are the activity of discretionary management of numerous examples of this type of pension clients' portfolios should be performed by a fund. They are, in effect, mutual funds with separate company, rather than by a certain added tax benefitsg0 and with the department. There is a strong argument for restriction that a participant will incur a separating the two activities, particularly if penalty if withdrawals are made prior to the securities company is a broker-dealer reaching a certain age or retiring. and also engages in corporate finance work. There is an inherent conflict of interest and 147. There is a strong case, therefore, for difference of style between brokers and setting common standards for those wishing investment managers. The broker lives from to engage in asset management activities commission on transactions and clearly within whatever context or parentage. wishes that turnover should be as high as Typically, these standards apply only to possible to generate maximum commission. those wishing to manage third-party Investment managers should have no portfolios and not to the internal interest in transactions for their own sake management of insurance or pension but only on the total return (dividends, portfolios. However, many regulatory interest and capital gains) that the portfolio regimes require internal managers to adopt managed can consistently generate over time. most of the standards (competence, conduct Broker-owned asset management businesses of business, avoidance of conflicts of tend to be turnover-driven rather than investment driven. 89The premiums payable attract tax relief; or the life 150. Ideally, therefore, securities company ownership of assets provides shelter from companies might be required to establish capital gains and income taxes; or the proceeds are tax-free on maturity or death. separate asset management subsidiaries, 90Contributions may be tax deductible; the funds with separate personnel and systems, for the may be free from capital gains and income taxes purpose of discretionary management. andlor the resulting pension payments may be free of These subsidiaries should conform to the tax. rules applying to asset management based 12b-1 fees, while class B is a hybrid companies generally; they should also be of the two, relying on contingent deferred supervised under the same regime+apital sales charges, or declining backend loads.). adequacy, qualifications of personnel, Recently the complexity of the 12b-1 systems, etc. This will have the effect of arrangements and their relative opacity have harmonizing the regime for asset been called into question. The US Securities management generally and create a level and Exchange Commission (SEC) in its playing field between asset management testimony to the Senate Banking Committee companies under different ownership, i.e., on March 2004 said, "Over time, rule 12b-1 investment fund managers, pension fund has come to be used in ways that exceed its managers, insurance companies, trust original purpose. Consequently, the investment corporations and (possibly in the Commission is seeking comment on whether future) banks. rule 12b-I continues to serve the purpose for which it was intended and whether it 151. Setting common standards for all should be repealed. " investment managers will involve detailed regulations that should cover a number of 153. The main principle is that there is key areas, including: equality of treatment4.e. that a published charging and commission tariff is adhered to (a) Capital adequacy and solvency; so that all customers in the same category (b) Resources and systems; pay the same fees and that no intermediary (c) Competence and skill of personnel; is given special deals. (d) Conduct of client business; (e) Conflicts of interest; 154. There are other ways in which agents (f) Advertising, marketing and selling; and can be remunerated that have recently (g) Transparency, disclosure and reporting. caught the attention of the SEC. One of these is "directed brokerage," where the 152. By way of illustration, the marketing fund manager directs transactions of the and selling of mutual funds has recently fund's portfolio to brokers who have been a subject of great debate in leading purchased fund units for their clients." financial centers. In the United States, sales and distribution of mutual fund shares are 155. In the UK, shares and units of governed by the National Association of collective investment schemes can only be Securities Dealers ("NASD"), that has an sold through authorized firms subject to the extensive rule book. The charging and regulation of the Financial Services commission structure of mutual funds has Authority (FSA). These firms are mostly become increasingly complex in recent remunerated through an initial commission years, following the adoption of rule 12b-I paid by the management company out of the in 1980. Under this rule some distribution front-end load. There is no limitation on the expenses (i.e. commissions to sales agents) amount of commission that can be paid, and may be paid out of fund assets subject to it must be said that the system is rather certain limitations. Most funds that are sold messy. Some intermediaries may be offered through brokers are offered with different share classes, each of which has a different -- 91For a very full analysis of US mutual fund fee schedule (Class A shares rely primarily distribution, see Investment Company institute on front-end loads from which commission Perspective : Vol. 9/No 3 dated July 2003. is paid; class C shares rely more on asset- special commission deals and their clients Level Playing Field offered incentives by way of price discounts. 160. In China, the terms for obtaining There is a whole range of discount brokers, permission to enter and to continue to who are prepared to cede part or all of the perform any business are sufficiently commission they receive to the client, thus unclear, as to place considerable power in enabling purchases of load funds at what is the hands of those who grant the licenses. effectively no-load. 161. While this holds some advantages in 156. The UK also has multi-share class allowing the state regulators to keep out funds with varying charging structures. undesirable applicants, who may qualify to Sales agents can be paid both front-end be granted a license on all counts except commissions and "trail fees" that are similar their perceived fitness and propriety, it has to 12b-1 fees in remunerating agents for many disadvantages too: retaining their clients' holdings. The difference is that, unlike in the US where the (a) It tends to perpetuate monopolies, 12b-1 fee is a charge on the fund's assets favoring existing large players and well (and thus paid by ongoing shareholders), known domestic enterprises, while trail fees are paid by management excluding new entrepreneurial entrants, companies out of their own revenues. domestic and foreign alike (some of which may be low-profile yet highly 157. The main principle in the UK is that reputable institutions); an agent must disclose to the client the remuneration that he will receive from any (b) By limiting access to licensing, it drives transaction done for that client. (FSA businesses underground rather than Conduct of Business Rules 5.7.5). allowing them to be visible in the formal sector; 158. In India, most remuneration of agents is by way of trail fees, since front-end (c) By requiring very large sums of capital loads are not common, except on equity and to be invested in new companies, it goes balanced funds. There has recently been against smaller entrepreneurial entrants, some pressure on agents to cease the driving these also underground; and practice of retrocession of part, or the entire, trail fee to the client as an incentive to deal (d) It provides an opportunity for those with with that agent. the power to grant licenses potentially to indulge in corrupt practices. 159. As the market for collective investment schemes continues to grow in 162. The Chinese characteristic of China, the CSRC will have to address all the predominant public ownership of banks issues discussed here and perhaps more, extends to the NBFI sector too. Most non- which should serve as a benchmark for the bank financial institutions are held by the other regulators, i.e., the CBRC and the public sector-utright or through CIRC, to write proper regulatory and governmental entities or state-owned supervisory frameworks for similar products enterprises-and have weak corporate offered by trust and investment companies governance. Appendices 1 and 2 show the and insurance companies, respectively. ownership structure of leading securities companies and fund management companies, respectively. 163. As a transitional economy, China has innovation is key to success. Even if the an obvious historical background of government continues to retain partial government ownership of financial ownership in certain financial institutions, institutions. Until the mid-1980s, the private owners should have effective control banking and insurance businesses, as in of those institutions' operations, which will many developing countries, remained a state facilitate the competent implementation of monopoly. And even though the securities commercial principles. business emerged in 1992, after two stock exchanges were established, public 166. If new domestic entrants are to enjoy ownership of securities companies and hnd a level playing field with existing players, management companies was common, as a foreign applicants should be allowed to result of a shortage of private capital and a compete on equal grounds with domestic lack of confidence in the security of private players too. In the context of China's sector institutions. financial system, the first and most obvious benefit of foreign participation would be 164. Whatever the motives, prolonged access to foreign expertise. This is public ownership of financial institutions particularly important in the capital markets, will in the long run involve palpable costs where local firms have far less experience while offering elusive benefits, if any. than foreign firms. The second order benefit, Publicly-owned enterprises are inherently perhaps more valuable in the long-term, inefficient with low business incentives, would be developing trust and confidence, little matching the market dynamism and the cornerstone of asset management innovative skills of private enterprises. It is business, for the domestic financial sector. not unusual for government-owned Notably, renowned international financial companies to sacrifice their commercial institutions will conduct their business interests to serve ad hoc public policies. activities in a highly prudent manner in Government ownership is also problematic order to maintain their professional because it may lead to considerable reputation. regulatory forbearance. Further, publicly- owned financial institutions enjoy an 167. It is also hoped that foreign implicit government guarantee of the participation in the management of products they offer. All in all, predominant investment funds, and possibly in the wider public ownership in the financial sector field of asset management for pension and leads to unfair competitive advantages for other institutional funds, will usher in publicly-supplied financial services, which advantages for the Chinese financial markets. can stifle the development of vibrant private The large multinational asset management sector alternatives. companies, which are known to be interested in forming, or have already 165. To encourage a rapidly expanding formed alliances, should be able to introduce private sector where entrepreneurs take the and transfer skills, including: lead in wealth creation and promotion of economic growth, government ownership of (a) Better investment analysis, asset financial institutions needs to be reduced allocation and stock selection, leading to going forward. The state should not only the training of a new cadre of Chinese allow, but encourage, the creation of investment professionals. This should genuinely private financial institutions, have useful side effects, such as especially in the securities business where improving the way in which securities are valued in the market, a better quality 171. For the government bond market, of issues, and improved corporate future debt management strategy needs to governance; focus on introducing T-bills and shorter- term (one- or two-year) T-bonds. These (b) The technology for mass administration instruments will be important for supporting and shareholder servicing systems, government cash management operations which will be needed to keep and for the development of the money management costs competitive if many markets. investors are to be attracted; and 172. As for the corporate bond market, (c) Better information to investors through issuers with good credit quality should be higher quality prospectuses and annual allowed to issue corporate bonds provided reports, leading to better investor they are subjected to a rigorous credit understanding of the potential upsides review by competent credit-rating agencies. and downsides of investing. The post-crisis revival of the Asian domestic bond markets-notably Korea, Singapore 168. As mentioned in the preceding and Thailanheflects corporate Asia's sections, it is encouraging to see that need to safeguard against currency and term- Chinese regulators are taking swift actions mismatch risks. The same force should also to implement WTO commitments for the be at play in China, coupled with enabling financial sector. Earlier than expected, the elements including a high savings rate, low CSRC issued on June 3, 2002, the rules domestic interest rates and low inflation. outlining foreign participation in fund More importantly, China's massive management and securities business. infrastructure program also calls for an Notably, the rapid establishment of joint efficient bond market that is capable of venture securities and fund management mobilizing long-term funds for long-term companies are respectable boosts to the investment projects. otherwise tarnished image of the financial services industry. 173. The necessary legal and regulatory framework should be created for introducing Availability of Wider Range of Investment 92 asset-backed securities (ABS) and Opportunities and Products mortgage bonds to the market. Asset 169. One of the constraints on asset securitization could provide an effective management in China today is the means for trading impaired assets held by inadequate supply of investment instruments. the four asset management companies This is especially true of fixed-income (AMCs). securities. In particular, products that are lacking--shorter-term instruments, 174. One of China's biggest constraints in corporate bonds and financial developing the debt market is the existing derivatives-render rational portfolio pricing restriction on financial assets, i.e., management and asset allocation difficult. the interest rate control system. It will be very difficult to see significant progress 170. Specifically, the viability of fixed- toward a deep and professional debt market income investment funds is predicated upon if such restrictions are not addressed in an the availability of a wide range of bonds, expedient manner. Ideally, the market bills and money market instruments. 92PBOC is reportedly working on drafting ABS law. should offer both risk-free (government options are widely used elsewhere, not only issues) and risky (corporate papers of as a means to manage risk but also as a cost- varying credit ratings) fixed-income effective way to re-balance and alter the securities. This will stimulate the maturity of portfolios without incurring high development of fixed income funds across transaction costs. These are not yet the credit spectrum and risklreturn available in China. continuum. 179. The supply of quality equities should 175. An important yet often overlooked be increased. To this end, the state should issue is the quality of credit information proceed with its original plan to sell state- services. Credit information services are owned shares of listed companies provided fundamental to fostering diversity and that the policy is implemented to minimize liquidity in the domestic bond market. In disturbance of the equity markets. The China, however, the credit information authorities need to develop comprehensive industry is thwarted by poor issuer divesture plans for SOEs that will combine transparency and corporate governance. On sales to strategic investors; block sales to the demand side, institutional investors have private investors; and partial IPOs on the yet to see the value of credit rating services. equity markehg3 A strategic plan covering As a result, credit information service a large number of different SOEs, with providers find it very difficult to make ends advance information about possible LPOs or meet, let alone uphold the objectives of sales would enable long-term institutions to independence, professionalism and core plan their investments on a longer-term and competence. rational basis. It may also help eliminate the speculative rush to purchase any IPOs, a 176. Deep liquidity is essential, since characteristic peculiar to the Chinese market. active management of fixed-income fund portfolios is necessary for those managers to 180. This systematic plan would replace achieve higher returns than others who the ill-fated plan, officially scrapped in June simply buy and hold. This will be 2002, of selling 10 percent of the state particularly important in China, where the shares in IPOs and rights offerings to differential in yields between retail bank replenish the NSSF. While many options deposits and government bonds is negligible. for re-launching the sale of state shares have A very active management approach will be been identified, there are no clear-cut necessary to give investors value for the fees solutions. The future mechanisms for that will be charged on the investment funds themselves. 93In October 2002, the CSRC enacted "Regulation on Listed Company Takeovers." The new measures 177. Along this line, bond market are expected to facilitate block sales of shares by segmentation needs to be addressed and creating a comprehensive and stable legal basis for improved. The guiding principles should be the M&A market. Under the new regulation, no broader market access; flexible trading limits are placed on the type of entity-the state, a systems; market competition; and effective private firm, or an individual-that can engage in the takeover of a listed company. As for the means of regulatory coordination. acquisition, shares and assets swaps are now allowed; previously only large sums of cash could be used. In 178. Additional tools are also necessary addition, the new rule allows for applying different for the efficient management of fixed- prices to tradable and non-tradable shares, i.e., it income portfolios. Interest rate futures and allows the purchase of non-tradable shares at a substantially discounted price. selling state shares would have to address practices, which restricts institutional the historical problem of substantial price investors' ability to manage diverse and differences between tradable and non- balanced portfolios. tradable shares of existing listed companies. Across-the-board measures to resolve this 183. Developments in the insurance sector discrepancy and to develop mechanisms for illustrate how the current system works further disposals of state shares may not along a gradualist approach. The Insurance prove viable. The state may have to accept Law of 1995 (Article 104) states that some price difference and let stakeholders insurance company assets may be invested (investors, underwriters, and company only in bank deposits, government and executives) collectively decide the valuation financial bonds, and other assets approved on a case-by-case basis. by the State Council. The CIRC issued a measure in July 1999 to include as an 181. In addition to sales of non-tradable investment option central government state shares, the CSRC should open up the enterprise bonds with a rating above AA. In stock exchanges to good private companies August 1999, purchases of bonds in the and reduce its role in the P O approval inter-bank primary market were included as process. The IPO system has improved, i.e., permitted investments. At end-1999, from the old quota system to an IPO review insurance companies were permitted to committee (1999) 94 to the latest indirectly invest in equities up to 15 percent "sponsorship system (2004)" under which of their total asset through securities the registered sponsors will be held investment funds. In October 2000, responsible for the behavior of each insurance companies were allowed to sponsored firm for a post-PO period of two engage in secondary bond trading in the years. The new and tougher IPO rules could inter-bank market. Thus, every expansion of send a signal to corporate executives and permissible investments required a new investors alike that the PRC equity market authorization from the government. The no longer would serve as a convenient October 2002 Insurance Law amendments refinancing apparatus for SOEs with further removed certain specific investment questionable commercial prospects. restrictions and authorized the State Council to approve new forms of permitted Relaxation of Investment Restrictions investments. Accordingly, the CIRC 182. The regulations on permissible allowed insurance companies to invest up to investments for institutional investors need 20 percent of funds in corporate paper95(up to be improved. China has, in general, a from 10percent) in June 2003. restrictive system of investment options for 184. Table 7 summarizes permissible financial institutions. Typically, different investment products by type of institution. investor groups are subject to different Despite continuous efforts by regulators to investment restrictions. The list of permissible investments often contains limited options vis-a-vis international 95 94The committee was composed of professionals Insurance companies are no longer limited to from the CSRC and outside market experts. It had investing in only four issuers (i.e., China Mobile, been structured with its members rising to 80 from State Power, Three Gorges and Ministry of Railway). 34, three-fourths of whom were currently non-CSRC Rather they can invest in bonds with a domestic members. rating of AA or above. relax and codify 96 investment restrictions, the current system expressly prohibits investments that are permitted in other markets. As a related issue, it is not always clear what investments are permissible for financial institutions. 185. Clarity is also lacking with regard to permissible investments for insurance companies with funds raised from unit- linked products. Since there are no investment guidelines specifically addressing unit-linked products, insurance companies applied general investment restrictions for insurance funds to these products. According to a recent report on the CIRC's plan to relax investment restrictions for unit-linked products, the CIRC has reportedly given its consent to three insurers (Ping An, Xinhua and Zhonghong) to invest up to 100 percent of the unit-linked product funds in securities investment funds. '' Most notably, the enactment of investment guidelines of National Social Security Fund by the Ministry of Finance in December 2001. Table 7. Investment Restrictions at a Glance Institutions Permitted Prohibited Loans Government Bonds Equities Banks Discounting Bills Investment Funds Inter-bank Call Loans Real Estate Corporate ~ o n d s ~ ~ Equities Investment Funds (Cross- Government Bonds Investment) Investment Funds Corporate Bonds Real Estate Cash Bank Dezlosits Bank Deposits Government Bonds Equities Corporate Bonds (with Real Estate Insurance Companies limitations) Loans Investment Funds (with Overseas Investment limitations) Government Bonds Real Estate National Social Security Corporate Bonds Overseas Investment Fund Investment Funds Equities Bank Deposits and Money Market Instruments Real Estate Corporate Pension Funds Fixed-income Securities Equities Bank Deposits Equities Trust and Investment Government Bonds Companies Corporate Bonds 1 Investment Funds 1 Real Estate Source: WorldBank. 97"Domestic banks are not explicitly prohibited from nor permitted to purchase corporate bonds," Chao and Gounaris (2002, p.5). However, the prohibition against commercial banks opening accounts at the stock exchanges (for custody of listed corporate bonds) is believed to be a technical impediment to such activities. 186. The "restrictive and indicative (d) Conflicts of interest are usually system" common in China contrasts with the clearly defined in regulations and "prudent person" approach to investment understood from legal precedents. portfolio management in countries where the However, professional asset common law is in use, e.g., US and UK. managers can often profit from Under the "prudent person" model, asymmetrical information at the investment options are not specifically expense of clients. Hence, restricted; instead, trustees and/or asset transparency and disclosure managers are expected to apply the rules of should be W h e r enforced. appropriateness and suitability, taking into consideration a portfolio's stated strategic 188. The "prudent person" approach is objectives, contractual agreements between useful in that it avoids the need for constant clients and asset managers, avoidance of re-categorization of permitted investments conflicts, and such factors as guarantees. as markets become more complex and diverse and as new types of security or other 187. The means by which standards of asset classes emerge. Under a restrictive investment management practice can be system, the regulators responsible for enforced are diverse: categorizing permitted investments need to issue ongoing and more detailed updates (as (a) Trustees can be engaged to apply has been the case in China, and as is "prudent person" principles over highlighted for the insurance sector). 98 investment management However, the "prudent person" approach is activities. Trustees may be open not without risks for countries that are to personal lawsuits if the unfamiliar with the concept of fiduciary beneficiaries can prove damage responsibilities. In these jurisdictions, both as a result of the trustees' investment managers and regulators are imprudent actions or negligence. inexperienced with managing and regulating activities with different investment horizons, (b) For failure to observe the terms, while clients demand returns that can only or negligent breach of a be achieved by significantly raising the level contractual agreement between a of risks. client and an asset manager, the client, a trustee, corporation or 189. In the case of China, the giant leap individual, may bring an action from the current highly restrictive regulatory for damage against the manager. regime to the fiduciary duty-based "prudent person" approach will create unnecessary (c) Regulators too may apply the risks and therefore cannot be recommended. concept of best advice and A gradualist reform approach will be more suitability of advice given to likely to give the desired result. This individuals, trustees or approach was adopted by the Chilean corporations, and take action if pension sector, 99 which remains a well- they can show that advice given was inappropriate to the needs or 98 For an excellent review of the two different circumstances of the client (i.e., regulatory approaches, see Vittas (1998). involved excessive risk). 99In Chile, there was substantial involvement of foreign institutions in pension fimd management companies, as there were in other Latin American countries that adopted the same model. This is known and successful model for the investments being confined to pre-approved development of institutional investment. categories of assets. This approach is common in newer markets: the regulator 190. There is no simple answer to which lacks confidence in the managers' ability to of the two approaches-"prudent person" or adopt sensible and low-risk investment "restrictive and indicativem-will yield the strategies; domestic instruments may be in better results, although some analyses short supply; or the government wishes to suggest that the "prudent person" approach channel investments in particular directions yields better results in the long term,'OO In (e.g., twenty years ago in France, collective reality, most countries adopt an amalgam investment funds were obliged to hold a approach for different types of investment percentage in government bonds). Statutory institutions (pension funds, insurance investment restrictions have been companies and mutual funds), but at the subsequently relaxed as local financial same time ensure that the less specific intermediaries and capital markets become prudential rules are in place. These include more transparent and better regulated by portfolio diversification requirements; appropriate supervisory authorities. As long prohibitions against conflicts of interest; as a wide range of investment opportunities limits to market power and other factors, e.g., exists, institutional investors may have little investment risk and liquidity; and problem under a positive system in meeting investment suitability for different types of multiple objectives, inter alia, achieving portfolios. adequate rates of return, managing risks and matching assets to liabilities. Box 2 191. As a way forward, regulators in summarizes best practices on permissible China are advised to conduct a thorough assets for CIFs and insurance companies in review of the categories of investments developed markets. permitted for the different categories of institutional investors. Investment rules should be specific and clearly defined, and should be readily available to institutional investors and applicable to all institutions that fall within the same category, not just to selected favorites. 192. Further, the investment regime needs to be considerably relaxed. In fact, many countries adopted an "indicative system," because the specialized pension management companies were set up as free-standing entities and were specially regulated. Local banks were kept out of the pension fund management industry in the early years of its development. In China, as in the European model, insurance companies are making the running in private pension provision. There are so many local and cultural issues surrounding pension generation and distribution that it cannot be said that any particular model is better than any other for a particular country. loo Davis (1997). Box 2: Permissible Assets for CIFs and Insurance Companies CollectiveInvestment Funds (CIFs) The permissible assets for collective investment funds (CIFs) are generally selected for their characteristics of liquidity and transparency, along with the issuer's s~undness.'~'Open-end CIFs are required to limit their investment in illiquid assets to a small ratio, usually a maximum 10percent of a portfolio for reasons of liquidity (since they may be obliged to sell assets to meet redemptions) and valuation (since it is important to be able to value the assets at market price regularly and reliably). Permissible assets for CIFs typically include: Cash and deposits: deposits with banks, certificates of deposit, commercial paper; Bonds: government bonds, municipal bonds, agency bonds, corporate bonds, convertible bonds; Equities: listed shares, unlisted shares (limited figure). Holdings of real estate are usually not permitted to open-end CIFs. Closed-end corporate types of CIFs specialize in investment in real estate (Real Estate Investment Trusts in the US and Property Companies in the UK). Insurance Companies In advanced markets, insurers have a wider range of permissible assets. EU Insurance Directives, for example, permit the following: Investments: a) debt securities, bonds and other money- and capital-market instruments; b) loans; c) shares and other variable-yield participations; d) units in investment funds; e) land, building and immovable property rights; Debts and claims: advances against policies, among others; Others: tangible fixed-assets apart fiom land and buildings; cash at banks and on hand; deposits with credit institutions, among others. In OECD countries, permissible assets include:102 Bonds (permitted in all member countries; no minimum floors reported; maximum percentages between 2% (Turkey) 5% (Poland) and 100%); - Shares (permitted in all member countries; no minimum floor reported; maximum percentages between 25% and 100%); Mortgages (not allowed in Turkey); Real estate (permitted in all member countries; percentages of 10%(Netherlands) to 100%); loans (permitted in all member countries except Poland); advances against policies in life insurance (except for Japan and the LK); and cash (permitted in all member countries except Mexico). 101This paragraph has benefited fiom Cadogan Financial (2000). '02OECD (2000). See Appendix 4 for detailed limits in each country. Increased Role of Banks Figure 9. Ownership Structure of Fund 193. Examples of bank-based financial Management Companies in Europe systems are common in the larger and more developed countries of the European Independent Union-Germany, France, Italy and Spain, 12% Banks and for instance. But each of these countries has Insurance made considerable efforts to develop its 6% capital markets. During this process, the Banks 53% ability of banks to undertake a variety of Insurance non-bank activities (e.g., asset management, 29% formation and promotion of investment hnds and pension funds and life insurance) has accelerated the development of these activities. Source: Oxford Ecotzonzic Research Associates Ltd. 194. This may be a useful lesson for Figure 10. Shareholder Profile of Fund China in mobilizing its banking sector for Management Companies in Selected the development of the country's Countries institutional investor base. As the banks in continental Eumpe did, the Chinese banks hold the bulk of household savings. Thus, they are in a good position to offer alternative investment opportunities to their L% Brokers customers. @ Independent Banks and Insurers 195. The 1990s witnessed the rapid Insurers growth of mutual funds throughout Europe Banks (including UK). With the exception of the UK, most European fund management companies are bank-owned. Figures 9 and 10 below give an impression of the ownership of asset management companies in Europe as a whole and shows different ownership patterns in certain countries of Source: Oxford Economic Research Associates,Ltd. Europe. The data is from 1998, but it is unlikely that there have been substantial 196. The universal banking model '03 is changes in ownership patterns since that well established in Europe and looks likely time. The domination of banks and to continue to dominate non-bank financial insurance companies is clear, even in the UK, which is less bank-dominated: '03In theory, the universal banking model refers to production and distribution of all financial services in a single legal entity. Few if any examples exist internationally. In practice, universal banking refers to production and distribution of commercial banking and investment banking products in a single legal entity, in some cases with insurance products produced and/or distributed via a separate subsidiary. activities. Europe has never had a "Glass- (b) record-keeping, subscription, bid Steagall" type of legal separation of banking and redemption of all fund types; from non-banking activity. Even in the UK, (c) securities agent in a very there is a clear trend toward the domination restrictive sense;lo5and of non-bank activity, particularly of mutual (d) insurance agent. fund management and distribution, by banks and insurance companies at the expense of 199. As mentioned in earlier sections, in the independent asset management June 2002, the PBOC allowed the four state- companies. In the US too, with the repeal of owned commercial banks to offer Glass-Steagall by the Graham-Leach- marketable government bonds to retail Blighly Act in 1999, there is a developing investors through designated branches. In trend toward bank ownership of asset September of the same year, the PBOC management companies, although the large further approved 39 commercial banks to set independents-Fidelity and Vanguard, for up government bond sales desks to serve example-remain strong for historical their corporate clients. In the corporate reasons. It remains to be seen how far this bond market, Chinese commercial banks are trend will persist in the US market. banned from underwriting corporate debt,lo6 but for customer relationship and fee income 197. Vis-a-vis the world's financial generation purposes, some banks acted as centers, China has one of the most restrictive guarantors of corporate issues. Again, this regimes for permissible banking highlights the restrictions on commercial organization activities. According to a 2003 banking activities in the capital markets global survey lo4 by the Institute of arena. International Bankers, China was the only country among the 44 surveyed to prohibit 200. Meanwhile China's separation banks from practicing securities, insurance, principle has not served to completely real estate and investments in industrial prohibit financial services integration. First, firms altogether. two of the four state-owned commercial banks engage in the securities business via 198. In China, the role of banks in capital subsidiaries. As previously explained, BOC markets is confined to the intermediary and CCB are undertaking investment business, providing a distribution network as banking and securities brokerage activities agents. On July 4, 2001, the PBOC issued indirectly through BOCI International the "Interim Regulations on Intermediary (China), Ltd. and China International Business of Commercial Banks" ("Interim Capital Corporation, Ltd., respectively. Regulations"), which described the definition, scope, and approval procedure for the intermediary businesses. According to the Interim Regulations, intermediary 105For specification on the agent of securities businesses of commercial banks in the capital market include: business, the "Notice of lmplementing the lnterim Regulations on lntermediary Business of Commercial Banks" by PBOC on April 22, 2002, clearly stated (a) investment hnds custodian; that a bank, while acting as an agent of securities business, may not engage in the buying or selling of equity securities. 106Apart from China Development Bank, which is 104Appendix 3 illustrates the main findings of the allowed to underwrite corporate bonds issued by survey for selected countries. existing clients. 201. Second, financial conglomerates do 204. The CBRC will likely continue to exist. They include CITIC Holdings and prohibit banks from engaging in any form of China Everbright (Group), Ltd., whose equity-related business due to fears of equity businesses reach into every comer of market speculations. In fact, allowing banks China's financial sector, including the to engage in securities dealing and industrial sector (see our discussion on the underwriting activities represents a real risk evolution of financial conglomerates in to banks' solvency. It was the collapse of chapter 4). Both groups were established banks in the US Great Depression (1929- before 1993, prior to the introduction of the 1933) that led to the enactment of Glass- separation principle. Steagall. In Russia, the 1998 banking collapse was caused by the dual impact of 202. Third, to date no specific law the massive sell-off of government bonds, as directly addresses financial holding well as the securities operations of companies, (i.e., whether they are permitted commercial banks. For these reasons, and if so, in what form). This lack of clarity banking regulators in most jurisdictions renders the holding company structure a would prefer to isolate the securities feasible vehicle for evading the segregation business from banking activities. constraint. The prohibition against banks' investing in non-bank financial institutions 205. In order to promote the development is clearly stated; in contrast, however, an of institutional investors in China, however, industrial corporation is not prohibited from the government should re-consider owning both a bank and non-bank financial commercial ownership of NBFIs. The basic institution at the same time. Thus, it is tenet lies in depositors' trust in the country's possible for a holding company to integrate banking system. As such, the entry of the different financial segments under one commercial banks into non-bank services roof with financial subsidiaries and affiliates might prove a more reliable yet less having access to capital markets. politically risky avenue for deploying retail savings vis-a-vis securities companies or 203. Since the specific exceptions from independent investment managers. the separation principle cited above were basically associated with privileges tied to 206. Since banks already act as agent- state-owned financial institutions or with distributors of life insurance and investment historical legacy, there is no guarantee that products, it would be a fairly short step others-banks and industrial enterprises forward to allow banks to own the alike-will be able to obtain government originators of the products-investment approval to copy the CITIC or the BOCI managers and life insurance companies-r approach to form a financial holding to sell own-branded products managed by company. However, amid increasing other originators which convey the concerns about stiff competition from impression to customers that they are the foreign financial institutions offering the full bank's own. Banks will need incentives to line of financial services after China's WTO develop non-banking activities, since they entry, the government is set to re-examine will be concerned about deposit loss. Small the current strict segregation principle in commissions for selling products will not order to nurture a more conducive likely be a sufficient incentive to attract environment for the development of banks more deeply into non-bank financial financial conglomerates. activities. 207. Of greater importance is devising a PAYG contribution requirement. lo' 1n system that recognizes and minimizes the addition, the government needs to provide inherent conflicts of interest among the strong legal and regulatory frameworks for different activities-commercial banking, corporate pension plans, along with more investment banking, brokerage and asset attractive tax incentives for contributions by management. If banks are permitted to own both employers and employees. (in whatever form) life insurance and investment management companies, the 210. If funded schemes of any type (i.e. amount of capital required should be non-PAYG schemes) are to be successful, to properly definedio7and be reflected in the win the trust of participants and to fulfill overall capital adequacy requirements of a their long-term function of providing bank. adequate pensions, their assets should be clearly separated from those of the Pension Reform sponsoring entities and managed professionally. Here international 208. The long-term development of experience may be valuable in institutional investors depends significantly understanding the successes and many on pension reform. Not only do pension failures of pension regimes vis-a-vis the schemes have long investment horizons, legal structures within which pension funds making it possible for them to become operate and the protection of the interests of significant equity investors, but they are also participants. major investors in longer-term government and corporate bonds, the balance between 211. Whether second pillar schemes are the two being largely a result of the sponsored by the state and municipalities proportion of contributors to pensioners and (including the NSSF), or third pillar of the age profile of participants. schemes are sponsored by enterprises for 209. Corporate pension funds have a their employees or result from contributions potential to exhibit the most solid growth by individuals, it is particularly important that any new guidelines for both mandatory pattern in the entire pension sector in China. Of course, in the SOE sector where total and voluntary pension funds include the following principles: employer contribution rates remain exorbitantly high, few companies would (a) The assets of the pension fund must be afford to establish supplementary pension clearly distinguished from the assets of schemes. However, growing non-SOEs in the sponsor (an enterprise or an the private sector would have bigger insurance company offering individual interests in enterprise pension plans if the schemes) and held in trust in such a way government comes up with a less onerous lo' Non-bank activities may involve legal, '08Under the current system, non-state companies are operational and reputational risks. Reputational risk reluctant to take part in social security system is of particular importance since a major banking because they think their contributions will be used to institution cannot be seen to fail its customers. If a subsidize pension liabilities of SOEs, leaving little set subsidiary fails, the parent bank may have to aside for their young employees. As a result, non- subsidize or compensate for it (e.g., Deutsche Bank, state companies are either completely out of public when faced with a major scandal in its UK pension schemes (outright evading) or are making at investment management subsidiary, was prepared to best perhctory contributions by reporting pay nearly US$700 million). artificially low wages. that the fund cannot be construed to be contributions, so as to facilitate transfers part of the assets of a bankrupt entity; in the event of a change of career; (b) Pension fund discretionary management (d) Investment guidelines must be clear and must be undertaken only by properly specific in order to ensure diversification regulated and qualified managers; among asset classes, so as to eliminate (c) Rights to parts of the pool attributed to the possibility that pension funds could ind.ividuals in the case of defined be used to finance sponsoring enterprises contribution schemes must be clearly (possibly as far as a ban on investment in distinguished so that an individual may the securities issued by the sponsor). be able to determine at any time the current market value of accumulated 6 CONCLUSION 212. There is a tendency among 215. However desirable the policymakers, and not just in China, to look macroeconomic objectives in building at specific parts of the institutional institutions may be, this goal cannot be investment sectors in isolation from one achieved without establishing a rational and another. Thus pensions are regarded as an precise regulatory framework, designed to issue separate from collective investment ensure good governance and prudent funds or life insurance. This is often a management of the institutions that will function of the fragmentation of serve the public saver and investor. Fair and responsibility at the ministerial or prompt enforcement, without favoritism, is government level. the next step, since drafting laws and regulations will not, in itself, produce an 213. Misunderstanding of desirable policy honest and fair market. objectives is also due to viewing the scene through the wrong end of the telescope; 216. A brief summary of the issues that governments tend to consider this landscape might be addressed to develop sound from a macro-economic perspective, given institutional investment sectors is as follows: their concerns about their fiscal deficits, funding pensions and financing industry and (a) Pensions are, as always, the central issue. commerce, whether in the public or private China's existing pension system is sectors. facing considerable trouble. The defined contribution individual accounts are used 214. Clearly the structure and operation of to cover the deficits in the first pillar the Chinese capital markets is distorted at PAYG schemes and are not expected to two levels. At one level the legislation lacks contribute much to market development clear definition of key concepts and, as a in the short term. There is a good consequence, the roles and responsibilities chance, however, that the voluntary third of different institutions are indistinct. At the pillar schemes can begin to make a other level, consumers are offered an significant contribution and that the inadequate and ill-defined range of savings NSSF, which is starting to accumulate choices. The results of this are that the long- substantial reserves, may become a term value of the vast pool of savings is not major market participant. maximized, to the detriment of both the (b) At the same time, insurance companies national interest and investors. have a significant part to play in offering secure low-risk products. Insurance distribution. It seems logical to allow companies need also to broaden their them to offer a much wider range of scope to better offer more innovative products to their retail customers, as products. Insurance companies are the banks increasingly do in other countries. largest repositories of savings outside Whether banks are allowed to engage in banks and are enjoying strong growth in non-bank financial activities by means premium income. But they too are of a holding company structure or suffering from uncertainty about the through directly owned subsidiaries is permitted scope of their investment not a crucial issue. portfolios and the range of products that they may offer. The role of insurance 217. Very few governments take a holistic companies across a broad front needs to and long-term view of the means by which be defined with appropriate regulations savings are mobilized and channeled, to support their activities. preferring to tinker with tax or other (c) Asset management needs to become incentives and to allow market forces to more professional, and the licensing and determine the structure of long-term professional qualifications of asset investment institutions. The outcome thus is managers consolidated across different largely determined by the restrictions log sectors of institutional investment. The placed on some and the incentive^"^ given management, administration and to others. In developed countries, there are distribution of collective investment also powerful sectional interests which funds needs improvement, particularly lobby for retention or granting of regulatory when faced with the challenges of open- and fiscal privileges. So market forces are end funds and a more competitive highly distorted by the nature of the playing market environment. The range of field, which is constantly being tilted one products needs to be broadened; at the way or another. This is a less than efficient same time, the degree of risk investors way of directing the flow of funds that assume, and the returns they can finances not only industry and commerce, reasonably expect, should be clearly but also government. China is no exception. disclosed. More efficient administration and order processing should lead to a 218. China now has a good opportunity to significant reduction in annual learn from the mistakes of others and to lay operational costs, which are too high in a solid foundation for its institutional such a low-return environment. investors. Accomplishing this can serve (d) Institutional investors need to have their well the interests both of the nation and its investment powers more clearly defined. citizens in a rational and planned way, and The restrictions placed on the scope and ensure that market forces dnve development structure of their investment portfolios toward the most desirable objectives. need to be slowly eased once they have proved that they can behave in a prudent and responsible way. A level playing field for all institutions of a similar nature must be established. The role of banks needs to be considered carefully. 109Interest-rate control regimes and a strict merit Banks have the largest pool of customers review system for securities issuance, among others. and hold the key to wide product 110For exampIe, tax exemptions for government bonds. APPENDIX 1-MAJOR OWNERS OF TEN LARGEST SECURITIES COMPANIES OF CHINA I Company Name I Capital Major Owners and Their Shares I (RMB billion) I 1 China Galaxy 4.5 I MOF 100% Securities Guo Tai Jun An 3.7 Shanghai State-owned Asset Administration Company I Securities 16.38%, Shenzhen Investment Management company 15.74%, National Electric Company 5.37%, China First Automobile Group 4.02%, ~henzhenPower Group 3.22% China Everbright Group 16.41%, Shanghai Jiushi Company Guo Securities 14.47%, Shanghai International Group 13.28%, Shanghai State-owned Asset Administration Company 5.65%. Shen - . Neng Group 4.74% 4 Hai Tong Securities Group 14.12%, Shen Neng Group 12.16%, Jiangsu Sunshine Grouo 6.86%. Shanghai Lansheng Cornoration 6.61% Shenzhen Investment Management Company 19.01%, Securities National Development ~nvestmentCompany -1l.3%, Wuhan Chengcheng cultural Investment ~ r o u 5%, ~ . Shenzhen w Jiabei Investment Development Company 4.84% , Bank of Communications 4.04% China Securities Beijing State-owned Asset Administration Company 40.79%, National Development Investment Company 12.55%, China Travel Service Group 5.28%, China National Petroleum Corporation 5%, China Steel Industry and Trade Group 4% Guang Fa Securities 2 Liaoning Chengda Corporation 20%, Zhongshan Utility Group 15%, Jilin Aodong Medicine Group 13.75%, Guangdong Zhujiang Investment Company lo%, Guangdong Meiyan Group 8.4% CITIC Securities 2 CITIC 38.21%, YaGeer Group 9.7%, CITIC Guoan Group 9.7%, Nanjing Yangzi Petrochemical Company 6.06%, China National Cereals, Oils & Foodstuffs Imp. & Exp. Corporation 4.85% 9 China 2.4 China Merchants Shipping Corporation 12.98%, Communication Qinghuangdao Port Authority 10.16%, China Port Securities Construction Company 9.01%, Guangzhou Shipping Group 8.47%, China Merchants Shekou Industrial ZoneCo., Ltd. I 8% 10 China Everbright 2.6 China Everbright Group 51%, China Everbright Limited 1Securities. 149% Source: CSRC. Note: As of June 2002. APPENDIX 2-OWNERS OF FIVE LARGEST FUND MANAGEMENT COMPANIES OF CHINA Company Name Registered Capital Owners and Their Shares (RNIB Million) 1 1 1 Hua An Fund 150 1Shanghai ITIC 30%, Shandong Securities 20%, Shen 1 1Management Co., Ltd. I I Yin & Wan Guo Securities 20%, Orient Securities 1 120%, Zhejiang Securities 10% 2 China Asset 138 1China Securities 30%, Beijing Securities 20%, Management Co., Ltd. Southwest Securities 15.55%, Huatai Securities 15.45%, Xingye Securities 15.45%, China Sci-Tech ITIC 3.55% China Southern Fun 100 China Southern Securities 30%, Shanxi ITlC lo%, Management Co., Ltd. Xiamen ITIC lo%, Hai Tong Securities lo%, Great Wall Securities lo%, Hua Tai Securities lo%, Hua Xi Securities lo%, Xing Ye Securities 10% Bo Shi Fund 100 China Great Wall TIC 25%, Everbright Securities Management Co., Ltd. 25%, Jinhua TIC 25%, China Merchants Securities 25% 5 Da Cheng Fund 100 China Galaxy Securities 25%, Everbright Securities Management Co., Ltd. 25%, China Eagle Securities 25%, Guang Dong Securities 25% I I Source: China Galaxy Securities Company. Note: As of June 2002. APPENDIX 3-PERMISSIBLE ACTIVITIES FOR BANKING ORGANIZATIONS IN VARIOUS FINANCIAL CENTERS Insurance Country Securities Real Estate Bank Investment Industrial Firm in Industrial Investment in Firms Banks Australia Permitted Permitted Limited Permitted with Permitted with through limits regulatory subsidiaries approval (more than 15%) Brazil Permitted Permitted Generallv limited Limited to Permitted through through to holding bank suppliers to the subsidiaries premises bank China Not Permitted Not Permitted Not Permitted Not Permitted Germany Permitted, but Permitted Permitted with Permitted, subiect only through limits to regulatory insurance consent subsidiaries (suitabilitv of the shareholdkr) Japan Some services Some services Generally limited Limited to Permitted. (selling of (selling to holding of holding 5% provided total government insurance bank premises interest investment does bonds, policies in not exceed investment connection investing firm's trusts) with housing capital or net loans) assets Korea Permitted Permitted Generally limited Permitted, limited Permitted, up to through through to 60% of bank to 15% of total 10% of the bank's affiliates affiliates capital shares of non- capital, subject to financial regulatory companies consent (suitability of the shareholder) Russia Permitted Not permitted Not pernlitted Permitted, but not Permitted with more than in one regulatory financial- approval (more industrial group than 25%) United Permitted, but Insurance Generally limited Permitted to hold Permitted to make States underwriting underwriting to holding bank up to 5% of non-controlling and dealing in and sales are premises voting shares investments up to corporate pernlissible through bank 25% of the voting securities for nonbank holding company shares must be done subsidiaries of through: 1) a financial nonbank holding subsidiary of companies. a bank National holding banks and company; 2) a their nonbank subsidiaries subsidiary of are generally a financial restricted to holding agency sales company; 3) a activities financial - subsidiary of a national bank Source: Insti te ofInternation~;Bankers,Global S rwey 2003. 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