Abstract:

 It is a common understanding of the relationship between the government and banks in the academic circle that government intervention leads to the deterioration of banks’ capital and ultimately affects economic development. However, as a country widely believed to have strong government intervention in the banking industry, China has maintained good bank capital performance and steady economic growth in the past two decades, which is contrary to the classical financial development theory. By combing the historical experience of China’s financial system reform, this paper explains it from the perspective of control rights: the central government recovers the residual right of control over financial institutions that was missing after the decentralization reform through centralized financial supervision, and retains the real right of control in financial resource allocation for local governments to maintain local incentives, thus alleviating the contradiction between local incentives and agency risks in the central-local principal-agent relationship. It has achieved a good adaptation to the locally dominated economic growth model. This paper develops a theoretical framework based on the incentive compatibility mechanism of the central-local relationship, which provides new theoretical inspiration for understanding the reform of China’s financial system and the relationship between the government and banks in countries in transition.

Key words:

financial system reform, government intervention, central-local government relations; incomplete contract, residual right of control