New Financial Rules Could Allow China’s Smaller Banks to Fail. That’s a Good Thing.

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China’s too-big-to-fail banking rules are heading in the right direction.

Chinese regulators published new guidelines on Tuesday for supervising the nation’s financial institutions. Of course, Beijing owns most big lenders, and failures are almost unheard-of. But the very act of indicating which ones should be saved in a disaster means that others may be allowed to fail: That’s a step toward liberalizing a nearly $40 trillion banking industry.

The latest framework will label several more Chinese banks, securities firms and insurers as “systemically important,” meaning that they are so vital and connected that the collapse of just one could trigger a crisis. (The Financial Stability Board, an international regulatory body, already deems Bank of China, Industrial and Commercial Bank of China and some others as critical on a global level.) The blueprint unveiled this week will subject organizations in the enlarged group to tougher rules on capital requirements, leverage and so on. During a crisis, they may qualify for a bailout in exchange for meeting those requirements.

At first blush, the rules seem to be an odd fit. The point is to identify the most important institutions, toughen scrutiny and so reduce the likelihood of failure, or speed up a wind-down if they do trip up. It was a solution primarily introduced to address the concerns of Western governments after the global financial crisis, when many were forced into expensive and unpopular bailouts of private sector firms.

In China, however, there is no similar distinction between government and finance. The state owns the country’s largest lenders, as well as many insurers and securities firms. The last serious bank failure in China happened about 20 years ago. Chinese investors have come to expect that Beijing will step in when troubles mount, suggesting that almost every reasonably sized institution is too big to fail.

But there is a more encouraging message here. Those not on the list will, in theory, be minor enough to fail. Beijing will probably rescue even smaller banks for some time to come, regardless of the regulations. But officials are at least beginning to draw limits — and that’s critical if they are to ever remove a costly implicit state guarantee for the entire sector. As American and European governments learned, it is better to sketch those lines early: It’s much harder to do so during a crisis.

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