- China’s regulatory spotlight has fallen on wealth management products (WMPs) and certificates of deposit (CDs), instruments that underpin trillions of renminbi in trade in the interbank market.
- As it stands, highly leveraged smaller banks and non-bank financial institutions (NBFIs) could become dangerously exposed by moves to cut off liquidity and force the market to clean up.
- We expect the monetary authorities to step in and prevent a disorderly unwinding for now, but overly-leveraged institutions in the interbank system will face increasing stress ahead of, and beyond, the 19th Communist Party Congress in the autumn.
With a key Communist Party meeting on the immediate horizon, this may not be the year to risk unwinding leveraged trades in the Chinese financial system. But the authorities appear intent on gradually reining in financial system excesses and we see a growing risk of a repeat of 2013’s calamitous liquidity crunch.
New rules restricting the ability of smaller institutions to scale up using funding from WMPs and negotiable CDs threaten more ructions and increase the risk of institutional failure. However, given this year’s political sensitivities and the scale of the funding involved, we would expect the People’s Bank of China (PBoC) to tread cautiously and intervene to calm the market when necessary.
Longer term, we see greater volatility and rising risk. Market rates are likely to keep increasing and institutions may struggle to stay liquid as regulatory tightening ripples along a chain of funding that runs right through the Chinese financial system.
Damned if they don’t
Three years ago, retail depositors were by far the biggest purchasers of WMPs – short-term, rate-beating investment products marketed by banks. At that time fewer than 3 per cent of WMP investors were financial institutions (see chart). Increasingly, however, WMP funds are being invested in other WMPs by banks looking to boost profits by circumventing a rule that caps exposure to certain risky assets.
In a typical transaction, a large, deposit-rich state lender uses the proceeds from the sale of its WMPs to invest in the WMPs of a smaller joint-stock or city commercial bank. This smaller bank wants to invest these WMP funds in non-standard assets, including loans packaged in complex financial structures, such as trust beneficiary rights or asset management plans (see chart).
But the bank also wants to keep the WMPs off its balance sheet to avoid capture by regulatory capital standards. It therefore turns to an NBFI, such as a securities firm, to outsource management of the funds. The bank gets the guaranteed return, while the NBFI is given strong incentive to leverage up to maximise its exposure to the bond market or to non-standard assets.
With moral hazard continuing to underpin the Chinese financial system, this chain of funding has evolved to bypass previous regulations and maximise profits. Small and medium-sized lenders are at the heart of relationships that have generated massive cross-holdings and account for a large and growing slice of the WMP industry (see chart).
Outstanding WMPs stand at Rmb29.1tn ($4.2tn) – equivalent to nearly 40 per cent of GDP – and we estimate the financial institutions that invest in WMPs account for more than 17 per cent of that pool. Non-guaranteed WMPs, which are held off-balance sheet, accounted for 14 per cent of bank funding last year, more than double the proportion in 2013 (see chart).
Turning the screws
The authorities are now pushing forward curbs on these practices as part of a unified regulatory framework. The appointment of Guo Shuqing, a former deputy central bank chief, as head of the China Banking Regulatory Commission (CBRC), has injected new energy into the long-running game of cat and mouse between financial institutions and their regulators.
According to reports of draft regulations and CBRC documents circulating in the interbank market, this latest crackdown will include:
- A ban on financial institutions investing in the asset management plans of other institutions, as well as in non-standard credit assets;
- The imposition of maximum leverage ratios;
- A requirement that fund management institutions set aside 10 per cent of their fee income to cover potential asset risk;
- A ban on guaranteed returns for asset management products. We previously noted that large banks were quite happy to outsource management of WMP funds – if they no longer enjoy a guarantee the relationship breaks down.
These rules will directly impact the Rmb26.5tn in bank credit extended to NBFIs by the end of 2016 (see chart). Of this total, we estimate Rmb11.7tn has flowed into the bond market, Rmb7.5tn to non-standard assets and Rmb7.3tn to other financial investments.
Regulatory scrutiny has also turned to CD trading, which has become an important source of financing for smaller institutions. Issuance of CDs in the interbank market only began in late 2013 but hit Rmb7.9tn by the end of March this year, although much of this may be intended to replace maturing products (see chart).
Record CD issuance in March highlights a scramble among smaller institutions for funding. Despite rising interbank market rates, some of these lenders have priced CDs at nearly 5 per cent, more than they are paying investors for WMPs. They have rushed to borrow via CDs because sales may soon be restricted if these instruments are included in calculations of interbank liabilities under the central bank’s macroprudential assessment (MPA) framework.
Clean-up raises liquidity risks
Targeting these two important sources of funding signals an intensification of government attempts to encourage financial institution deleveraging after off-balance-sheet WMPs were included in the MPA from the start of this year.
The MPA is emerging as a key tool for the PBoC to ensure lenders meet regulatory standards, and Bank of Ningbo, Bank of Guiyang and Bank of Nanjing have already been penalised for falling short.
But tougher action risks bigger market ructions. Non-standard assets are generally illiquid – the reason the bond market was hit so hard by liquidity tightening in the second half of last year is because bonds are easier to sell (some 40 per cent of WMP funds are invested in the bond market). Clamping down on relationships along this financing chain may also force institutions to offload illiquid, non-standard assets.
This is what happened in mid-2013, when a deleveraging push by the regulators triggered market panic and a fire sale of illiquid assets. Interbank borrowing costs spiked to record levels as the system quickly seized up. A key difference now is that risks are concentrated among China’s smaller banks and financial institutions, while larger banks have generally offloaded their riskier assets, which lessens the systemic risk.
Ideally, regulators will be able to gradually nudge institutions to shrink their balance sheets, starting with highly liquid assets, while allowing non-standards assets to quietly mature.
Stability appears to be the watchword in the lead-up to the 19th Communist Party Congress, due in the second half of the year. Any threat of a dislocation and we expect the PBoC to step in with liquidity provisions, as it did last month amid reports some small institutions were unable to honour repurchase agreements after short-term rates spiked.