On 27 April 2018, China authorities announced major new asset management rules aimed at tightening shadow banking activities and reducing the systemic risks in order to develop a healthier domestic capital market. Fortunately, thanks to a long grace period for the new rules and the central bank’s commitment to stability in the financial sector, we expect the industry to adjust to the new rules and transition in an orderly manner.
China’s shadow banking
China’s shadow banking is a by-product of the past financial regulation. Historically, interest rates were fixed and financial regulations were narrowly focused on the booking entry instead of economic substance. Shadow banking activities sought to circumvent these restrictions and came in many different forms including wealth management products, asset management plans, trust products, etc. – collectively known as “asset management products” (AMPs). AMPs have become a significant source of systemic risk for China because of their size, complexity, interconnection, opaqueness and moral hazard problem. For investors keen to know more about shadow banking activities in China, the Bank for International Settlements published a detailed paper on this subject.
- Sizeable: In 2017, AMPs (excluding funds) grew to a size of about US$12.3trrepresenting approximately 93% of GDP or approximately 65% of bank loans.
- Opaque: In contrast to traditional funds and securities that are well regulated with transparent pricing and holdings clarity, AMPs usually disclose an expected return only, without much information about breakdown of actual investment or net asset value (NAV) on a timely basis.
- Complex: Some AMPs lent directly to ultimate fund users without loan accounting treatments, which is used by banks to evade regulations such as the 75% of loan/deposit ratio, 150% of provision/NPL ratio, and fixed interest rates on loans. Some AMPs invested in tradable securities with substantial leverage to enhance yields. To add further complexity, AMPs can also invest in other AMPs creating “layers” of AMPs.
- Interconnected: Commercial banks have played a critical role in shadow banking, both as major issuers of and investors in AMPs. Combined with non-bank financial institutions who are also major counterparties of the banks in China’s interbank market, this has created a complex web of interconnectedness that touches many aspects of China’s financial industry.
- Moral hazard: Even without an explicit guarantee, local investors generally believe that AMPs are implicitly guaranteed by their sellers. Further reinforcing this belief in the implicit guarantee are the examples of sellers compensating the investors for the loss in AMPs to avoid disputes.
Super-regulator with new super regulations powers
In November 2017, the government announced the establishment of the Financial Stability and Development Committee (FSDC). Headed by the vice-premier of China, the new “super” regulator aims to reduce opportunities for financial institutions to arbitrage the rules made by different regulators by aligning the regulations among different sub-sectors of the financial industry. Approximately five months after its establishment, the regulators published “guiding opinion on regulating the asset management business of financial institutions” to regulate AMPs issued by different types of financial institutions. AMPs may still exist in the future, but “new AMPs” have to comply with the following key rules and regulations.
Structural changes in competitive landscape
It will take time for investors to get familiar with new fund-like AMPs with periodically disclosed NAVs and without guarantees. AMPs unwinding their investment positions to get in-line with the new regulations could generate significant volatility and outflows in the near future. Mutual funds, especially money market funds, could become more competitive in the new, level-playing field, as the new rules are similar to the risk management framework of mutual funds. Meanwhile, direct participation of retail investors to the capital markets is also likely to increase.
According to the new regulations, banks are required to have independent dedicated subsidiaries to run AMPs, which will, in the long term, increase competition in the asset management sector and reduce banks’ reliance on third party asset managers. Surging structured deposits and retail certificates of deposits with yields higher than traditional deposits will likely become a common way for banks to capture outflows from AMPs in the interim.
Short term pain and long term gain in the capital markets
The combination of hawkish PBoC monetary policy and the new regulations has tightened liquidity, pushed up domestic bond yields and steepened the yield curve, but we believe most of the impacts are priced in and there should not be further substantial technical impacts on yield levels from the new rules in the near future. Weak companies, who previously relied on AMPs as their main fund sources, are facing incrementally more challenges to refinance their debts. The increased frequency of credit events has dampened risk sentiment and widened credit spreads.
Fortunately, the central bank remains committed to maintain stability in the banking system, as demonstrated by the reduction in the reserve ratio requirement in Apriland other measures to mitigate liquidity seasonality as well as to control systemic risk. Assuming an orderly transition, in the long term, the new rules should help build a healthier financial environment in China, with better transparency and stronger regulatory oversight. These developments underpin our constructive view on the financial industry of China.