When you spot a fire in a building, you sure know what to do call firefighters.

What if a "fire" breaks out in a nation's financial system, say, a run on a bank, or a breakdown in a bank's systems?

Do we have firefighters for those emergencies, or is there a standing mechanism to co-ordinate efforts to handle the situation?

The answer is no.

But there will likely be such a mechanism soon, and many government agencies, and maybe some new ones, will be part of the nation's upcoming financial firefighting system.

The State Council, China's cabinet, has approved a plan to tackle emergencies in the nation's financial system, the China Banking Regulatory Commission (CBRC) revealed late last month.

The CBRC is expected to complete a lower-level plan to fight emergencies in the banking system by the end of this month at the earliest, and is already taking measures to implement the State's plan, an official with the commission says.

The CBRC is currently defining responsibilities of departments for implementing the plans, training personnel, and preparing for drills and the establishment of an early-warning system.

Details of the plans are unknown as both the CBRC and the People's Bank of China (PBOC) rejected interview requests, but analysts say they represent major progress in the government's approach to handling financial emergencies.

"It's like having a firefighting regulation, which we did not have before," says Qin Chijiang, deputy secretary general of the China Finance Society and former head of the PBOC's research bureau.

"You know how to handle the liabilities and assets (of the financial institution involved) or how to treat creditors," he adds. "You don't have to hold ad hoc meetings like before."

China's financial authorities are anything but inexperienced on dealing with emergencies. The Asian financial crisis of 1997-1998 sent many of China's trust companies into bankruptcy in the following years.

While the number of trust companies amounted to as many as 700 in the 1990s, there are only around 60 now. Closures were also not rare among rural credit cooperatives, which are still undergoing a major restructuring that aims to turn them into profitable lenders.

All those emergencies were handled on a case-by-case basis. While methods and standards used differed sharply from one another, the lack of standard procedures to follow also makes it difficult to learn from experience and prevent mistakes from being repeated, analysts say.

"In some cases where the rural credit co-operatives had problems, the typical approach goes like this: first, the local government scratches together some funds to keep things going. Then, related departments sit together to authorize the use of deposits (at the cooperative in difficulty), and the central bank puts in some funds," says an economist who declines to be named.

"If those efforts fail, a team will be set up to handle the bankruptcy procedures," he adds.

A key weakness of the old approach, analysts say, is the frequent use of central bank lending, which affects the implementation of the nation's monetary policy since the central bank, technically speaking, increases money supply when granting the loans to help the troubled companies wade through the difficult times.

And there were other hazards, as the senior management of the financial institutions knew that the government, which puts top priority on social stability, would step in and clean up the mess, believing State ownership typically the case in China's financial sector justifies that.

"They always think the government will be there," says Wang Zhao, an analyst with the Development Research Centre, a think tank of the State Council.

A big part of the central bank lending to Guangdong International Trust and Investment Corporation before its sensational closure in 1999 in the wake of the Asian financial crisis still has yet to be repaid, a central bank official says. The company was the first non-bank financial institution in China to be shut down by the government.

If scratching the bottom of the barrel for solutions on a temporary basis worked in the past years, the approach will be less desirable in the coming years as the Chinese economy increasingly integrates with the rest of the world.

"With China's financial markets being increasingly internationalized, a crisis in the international financial market may have a direct impact on the Chinese markets, therefore triggering turmoil or a crisis," says Yi Xianrong, a senior economist with the Chinese Academy of Social Sciences.

Foreign institutional investors are already playing an important role in China's stock market under the QFII (qualified foreign institutional investor) scheme, which was initiated more than two years ago.

And the growing presence of foreign banks, which will be given full access to the local market by the end of next year, could lead to turmoil in the banking system. In the worst-case scenario, Chinese banks suffer an exodus of quality clients and fail to make any breakthrough in innovation, leading to a broad shrinkage in profits, while the long-standing interest rate spread between lending and deposits tends to disappear alongside the interest rate liberalization, says Zhang Yichun, a professor with the Xiamen University.

Yi goes further to suggest that as China removes controls on its capital account as planned, which served as a key buffer during the Asian financial crisis, the economy will be exposed to the risk of massive short-term capital flows, which are highly destructive.

Successful handling of emergencies could significantly reduce the damage. The Federal Reserve's US$80 billion injection of liquidity into the financial market three days after the September 11 terrorist attacks in 2001, and a prompt interest rate cut, played a key role in stabilizing the market and boosting investor confidence.

But a lot remains to be done in China to build a mechanism that not just stops a "fire" from spreading from one place to another, but prevents it from happening in the first place.

While the standard procedures for emergency action need to be set up and all necessary personnel and other resources put in place, Yi says more smaller banks should be established to gradually reduce the reliance of the economy on the four largest state-owned banks, which control 70 per cent of the nation's financial assets.

And it needs legislation to provide legal support for such emergency measures as forcing suspension of troubled financial institutions, using central bank lending as well as compensating depositors, he says.

The authorities are already moving. The central bank is leading efforts to build a deposit insurance system that will insure bank deposits. It is also reportedly drafting a regulation on the bankruptcy of financial institutions, paving the way for shutting down bankrupt financial institutions in a market-oriented manner.

(China Business Weekly July 12, 2005)