02/24/2016 11:38 am ET Updated Feb 24, 2017

Time Bomb Still Ticking in Chinese Financial Markets

China's mishandling of its financial markets continues to reverberate through its own economy and global financial markets. The Chinese leadership has just fired its chief regulator, Xiao Gong, after having stated that departments having major responsibility had taken "inadequate actions" and in addition "had internal management issues."

Simply firing Xiao Gong will not solve the underlying problem, which is structural and dangerous. In this regard, Chinese authorities, like their Western counterparts, have ignored the powerful insights about financial structure from the financial instability hypothesis (FIH) that was developed by the late economist Hyman Minsky. As documented in my new book Behavioral Risk Management, the FIH consists of twelve steps, the first eight of which induce financial instability, and the last four consisting of stabilizing measures.

"Regulatory Failure" is the FIH component most directly related to the Chinese leadership's remarks recognizing inadequate actions and internal management issues. The FIH stipulates that regulatory agencies will tend to be outmatched in resources and talent by financial firms. In this regard, financial firms will use complex innovation strategies to increase both leverage and risk to imprudent levels during periods of euphoria.

To be sure, until last year, Chinese markets were euphoric, especially markets for real estate and stocks. Many observers issued warnings about the associated fragility, including me in May 2015. Then in June, Chinese stocks began to decline dramatically and continued to fall during the summer. To stem the decline, Chinese regulators prohibited new initial public offerings, forbade large financial firms from selling shares, instituted circuit breakers, and allowed the Chinese currency to decline in value. Most of these measures failed, and were recently reversed, despite the loss of face to Chinese authorities.

In line with the FIH's concept of "Regulatory Failure," the Chinese regulatory system is weak. Xiao Gong himself acknowledged that Chinese market mechanisms were flawed with inadequate supervision by regulators. The regulatory agency, the China Securities Regulatory Commission, is lacking in talent and in the wake of Chinese financial instability has lost seasoned personnel. The agency has been criticized for lacking workers having international experience and connections. In addition, there are reports that last summer, agency staff members tipped friends about agency decisions before they were announced.

Xiao Gong received his undergraduate degree from Hunan University in Changsha. He received a Master's degree in law from Renmin University in Beijing. In 2007, a year before the full eruption of the global financial crisis, I visited both of these universities to lecture on behavioral finance. My main message in those lectures pertained to the dangers that irrational exuberance posed for China's financial system and economy. The lectures drew an analogy between the historical experience of stock market bubbles in the U.S. and the situation at the time in the Chinese stock markets. I suggested that Chinese authorities could learn from the U.S. experience.

Asset pricing bubbles comprise another component of the FIH. In 2007, Xiao Gong had already graduated from both Hunan University and Renmin. However, the message about asset pricing bubbles was still germane, and could become a salient part of the dialogue in China about mapping its future. The events which unfolded after 2007, especially after 2012, point to the key lessons from the FIH largely going unheeded.

When regulators fail during euphoric periods, imprudent leverage and risk develop. Shadow banking expands in a way that promotes what the FIH calls "Ponzi finance." In 2012, while he was at the Bank of China, a state-owned bank, Xiao Gong described the growth of shadow banking in China as "fundamentally a Ponzi scheme." Imprudent leverage, imprudent risk-taking, and Ponzi finance have combined to produce China's ticking financial bomb.

Subsequent events have proved Xiao Gong's Ponzi characterization as prescient. Had he been familiar with the FIH and taken it seriously, he might have been able to connect the dots. Had he sufficient control, he might even have been able to steer China onto a more prudent path. Nevertheless, policy decisions in China are very much top down, and Xiao Gong was not at the absolute top. The top position is occupied by Xi Jinping, the President of the People's Republic of China. He would be well-advised to do some reading about the FIH, and apply its lessons so that China and the rest of the global economy embark on a more prudent path.

The alternative is to leave the time bomb to continue to tick.