Introduction

The subprime crisis, which originated in the United States and shattered the global economy in 2008, offers valuable lessons on how a particular bank lending behaviour in one country, even a nation with high-level corporate governance practices and market regulation, can lead to a recession- generating collapse of the largest financial markets and several huge financial institutions. This chapter not only aims to understand the spreading mechanisms of the financial crisis and its effect on China's financial system, but also see what lessons China can learn and apply to its own financial system. What important issues does China have to cope with to maintain financial system stability in the future.

Since the Chinese financial system is relatively closed, the direct impact of the U.S. subprime crisis and the subsequent global financial crisis on China's financial system has been minimal, as was the case with the Asian financial crisis. However, the indirect impact through the real economy and government policies has been large and deep. Learning from the Asian financial crisis and Japan's prolonged economic recession, the Chinese Government has made a huge effort to reduce non-performing bank loans (NPLs), improve firms' corporate governance, and manage a controlled floating exchange rate for the RMB. The recent crisis offers new lessons for financial development, particular regulatory issues and the governance of financial institutions. If the Chinese Government takes proper measures and approaches to address issues related to these lessons, the crisis could actually offer China's financial system a major opportunity. That is, as long as government policy on foreign capital and institutional investors stays stable, we are likely to see an increase in financial capital investment, such as private equity and financial service industries, instead of the capital outflows typical for most emerging economies during any financial crisis.

This chapter addresses several issues that are important for the future development of China's financial system. First, investor protection is critical for stock market maturity, which in turn is critical for funding new industry.