Global standards essential for financial control

Regulators across the globe have enacted a continuing succession of new rules and regulations to help financial firms manage and reduce risk in all sections of the financial markets. Starting with the technology bubble of the late 1990s, an excessive enthusiasm about market opportunities and fraud has resulted in major shocks not only to the financial system, but to the global economy as well.

Market globalization means that all significant economies must reach a high level of trust and compliance for the global economy to remain viable and stable. China is now the world's second-largest economy, and so it must learn from the recent financial crisis and resulting recession in the West.

However, financial crimes, such as fraud, money laundering and terrorist financing, are not just Western issues. Risks increase as economies grow more rapidly, as illustrated by the downfall of a number of Chinese companies. The investment world has welcomed many Chinese companies to their global markets, but some fail quickly as accounting fraud and market manipulation comes to light.

According to an analysis by McKinsey, the aggregate market capitalization of Chinese companies listed in the United States fell in 2011/12 by 72 percent with around one-in-five delisted. As a result of some of the major Western frauds of the past, markets are increasingly distrustful of new entrants and the losses they have suffered from companies, such as Longtop and Rino International. Accounting fraud, lax regulation and the use of variable interest entities, a corporate structure previously used by the Alibaba group, are behind many of the losses.

In many cases, the fraud was obvious with inflated inventories and revenues being used to achieve high listing valuations and to attract investor funds. A major issue, though, is the lack of international trust in the quality of information provided during the listing processes. Chinese laws forbid international audit firms from releasing information on any audits performed in China. In some cases, listing exchanges based in New York and Hong Kong have taken action against the audit firms. However, they cannot send their own teams to China to perform independent reviews because of infringement of sovereignty concerns.

Such impositions would not be necessary if China adopts international accounting standards, such as International Financial Reporting Standards and relevant elements of the Sarbanes-Oxley. It also should rigorously investigate and prosecute both auditors and business management responsible for committing fraud. While nothing has changed yet, there are growing signs of future cooperation with the authorities in the US and the Hong Kong Special Administrative Region, as well as the likely introduction of IFRS accounting standards.

So how is China now progressing in addressing these issues and implementing global standards? And, where must it increase its focus in terms of doing so?

China now leads the way in implementing financial controls across the financial sector. If the China Banking Regulatory Commission continues to pressure financial institutions to fully implement the requirements, China will be at the leading edge of financial regulation and able to continue to open its markets to more sophisticated trading instruments.

The central bank is now introducing global standards across all financial firms to control the placement and integration of the proceeds from crime into the financial system. The new rules will be fully active in 2016 and should lead to much greater control and opacity. Financial firms will be responsible for implementing processes and controls to ensure compliance. These controls do not prevent fraud from occurring, but will make it more difficult for individuals and companies to abuse markets by illicitly moving funds. The Ministry of Finance and the CBRC are moving toward the application of IFRS. However, this should be enforced with all companies, not just financial firms. While the application of the standards does not prevent fraud, it does provide markets with a consistent way to value businesses from China that wish to list on international markets, including Chinese exchanges, as they open to international investors.

Variable interest entity structures are often used as a work-around for China's restrictions over ownership of businesses operating in sensitive industries. However, VIEs have left foreign investors with heavy losses because of the non-ownership of the underlying assets that they are investing in. Therefore, investors do not benefit by continuing to use VIE structures, and Chinese lawmakers need to review the foreign ownership restrictions in some business areas, such as Internet companies and training/educational businesses.

For the most part, China is making tremendous strides toward managing fraud and money laundering. However, there remains some uncertainty in determining how best to implement adequate controls and international business laws into its internal structures. With China's growth exceeding almost all other countries, it must catch up rapidly in areas of law and supervision to enhance and maintain the trust of the global investment community.

The author Michael Thomas is regional director North Asia at Wolters Kluwer Financial Services.