China’s Forthcoming Financial Stability Law

Overall supervision structure and working mechanism

The Draft FSL emphasizes that all financial activities in China must be brought under regulatory supervision and subject to regulatory approvals/licences. Regulated financial institutions that the Draft FSL applies to include PRC locally incorporated banking, securities, mutual funds, futures, trusts and insurance institutions, financial holding companies and other institutions engaging in financial activities that are subject to approval of or recognised by the relevant financial regulatory departments under the State Council.

A central government organ (possibly the CCP’s Central Financial Commission) will be the key policy maker / coordinator. The State Council’s various types of financial regulatory departments (including the People’s Bank of China (PBOC), the National Financial Regulatory Administration (NFRA), the China Securities Regulatory Commission, the State Administration of Foreign Exchange) and other relevant financial departments under the local provisional / municipal governments will be the policy executor and major regulators to prevent from and resolve risks, and investigate into and penalize illegal financial activities. The deposit insurance fund management institution established for the banking sector and other industry fund management institutions established for the securities, insurance and trust sectors (the Security Fund Managers) shall also perform certain risk monitor and resolution roles.

According to the Draft FSL, to effectively monitor and protect against systemic financial risks, the PBOC shall take the lead among all financial regulatory departments under the State Council to build up a macro-prudential supervision framework¹  covering the major financial institutions, financial markets, financial infrastructures and financial activities in China and be equipped with a policy toolkit to do so. A national financial database will also be established to facilitate information sharing and enable cross-agency supervision.

Recovery and early-stage risk mitigation measures

Where there are any unusual changes in the supervision indicators as stipulated by the various laws and piecemeal regulations², a financial institution is required to take various measures (such as adjusting or reducing balance sheet, suspending certain businesses, replenishing capital, suspending dividends distribution, limiting pay on senior management personnel or replacement) to voluntarily mitigate risks, and must report the same to its financial regulator in a timely manner.

The State Council’s financial regulatory departments may issue risk warnings, request interviews with the relevant financial institution’s directors, supervisors and senior management or its major shareholder(s), actual controller(s), and order rectification by financial institutions within certain prescribed periods. Where the rectification actions fail to address the issues identified by the supervision indicators, further restrictive measures may be imposed by the relevant State Council’s financial regulatory department, which may include:

• setting limitations on the financial institution’s business activities, dividends distribution, assets disposals;
• ordering the financial institution to write off instruments with loss absorption features or convert such instruments into equity (where the issue impacts the continuous operation of the financial institution);
• ordering the financial institution to replenish its capital in accordance with a recovery and resolution plan or to accept the performance of regulatory undertakings within a prescribed period³;
• ordering the financial institution to replace directors, supervisors and senior management, or set limitations on relevant individual’s powers;
• identifying responsible directors, supervisors and senior management as inappropriate personnel; and
• ordering responsible shareholders to transfer their shareholding / equity interest or limit their shareholder rights.

The restrictive measures will be lifted within three days after the financial institution subject to restrictions has completed the required rectification(s) in compliance with the financial regulation or to the satisfaction of the regulators after inspection.

The financial institution at risk may also be subject to a higher deposit rate at the discretion of the relevant Security Fund Manager.  Where there exist financial risks which may affect regional stability, the local government shall also take certain risk mitigation measures, e.g., supporting the financial institution to liquidate and/or dispose of assets, introduce social capital or implement a debt restructuring, so as to maintain the regional credit environment and social stability.

Risk resolution and creditors protection principle

Where a financial institution is subject to circumstances that jeopardize its continued operation and endanger the financial market order, the relevant State Council’s financial regulatory departments can decide to facilitate a reorganization, rectification, takeover, custody, revocation or bankruptcy of the financial institution, and the decision must be announced to the public.

In particular, when facilitating a reorganisation, takeover or custody of a financial institution, the State Council’s financial regulatory departments are empowered by the Draft FSL to, inter alia, impose a temporary stay (also known as suspension) on early termination rights under qualified financial transactions for up to 48 hours. This is the first time the “temporary stay provision” has been adopted in China’s official legislation and therefore has drawn great attention from the market. However, it remains unclear what constitutes a “qualified financial transaction”, and whether any exemptions may be granted to foreign financial institutions’ onshore branches in terms of their “qualified financial transactions”. Further clarification from the regulators is anticipated in the future.

The Draft FSL also sets out a general principle that the creditors and other stakeholders of a financial institution subject to risk resolution measures shall be entitled to receive the proceeds derived from risk resolution in an amount of no less than what they should have otherwise received had the financial institution gone into bankruptcy. A creditor or stakeholder may file an objection to the State Council’s financial regulatory departments should they believe the proceeds they received are insufficient, and the regulatory departments shall assess the difference and arrange to compensate for the difference where appropriate.

Financial stability guarantee fund

The Draft FSL generally provides that China will establish a financial stability guarantee fund as a back-up emergency fund resources to resolve financial risks. The fund will be primarily raised from financial institutions and financial infrastructure operators.  Subject to the State Council’s decision, PBOC may provide refinancing as a liquidity support to this fund. Further guidelines and rules on fundraising, management, use and governance of the financial stability guarantee fund will be separately released by the State Council.

Offences and penalties

The Draft FSL stipulates certain offences for financial institutions and their major shareholder(s) and actual controller(s), including:

For financial institutions:

• non-compliance with operational rules resulting in financial risks;
• non-compliance with reporting obligations or concealing the actual status of risks;
• failure to cooperate with or implement early-stage rectification measures, regulatory measures or risk resolution measures,   

For major shareholder(s) and actual controller(s), from the occurrence of the financial risks until they are duly resolved:

• illegal withholding of funds of the financial institution or its clients;
• illegal transfer of equity or assets of the financial institution, including distribution of dividends and bonus;
• entrusting others by major shareholder(s) (or major shareholder(s)’ accepting entrustment from others) to hold equity interests in the financial institutions, or the actual controller(s) concealing its actual controlling rights.

Penalties are likely to be imposed not only on the financial institution and its major shareholder(s) / actual controller(s) but also on directly responsible personnel, with fines, for institutions, ranging from RMB 1 million to RMB 10 million (or from 1 to 10 times the illegal gain should there be illegal gains exceeding RMB 1 million), and for individuals, ranging from RMB 200,000 to RMB 2 million.  If the violation is serious, the financial institution’s relevant regulatory licences or approvals may be suspended or revoked, and the responsible personnel may be disqualified or even be banned from practising in the financial sector for a certain period or, in serious cases, subject to a lifetime ban.

Possible exemptions to onshore entities of overseas financial institutions

Market commentaries during the past round of public consultation observed that several provisions under the Draft FSL may be too burdensome for the onshore subsidiaries or branches of foreign financial institutions that are of relatively small business sizes and are not systematically important. The Draft FSL generally provides that, with regard to the local subsidiaries/branches of overseas financial institutions and financial infrastructure operators, the said requirements shall be applicable unless otherwise expressly provided (or there exist other arrangements between PRC and other countries/regions for the maintenance of financial stability). This seems to suggest the potential for some exemptions.

The Draft FSL, once officially promulgated, will be the overall and top-level legislation to address and resolve the financial risks in China. The market expects that a final version will be available upon NPCSC’s third deliberation before the end of this year.