In November, we discussed how the post-Party Congress measures to deleverage and crackdown on the worst abuses in China’s credit bubble took an important step forward with the announcement of a new era of regulation for China’s $15 trillion shadow banking and asset management industry. See "A New Era In Chinese Regulation Means Turmoil For $15 Trillion In China's Shadows". In particular, the authorities turned their sights on wealth management products (WMPs).
On the way out are “guaranteed returns” and “capital pools” which had turned the $4 trillion sector into a leveraged Ponzi scheme. We joked that in a “radical and shocking” departure from the norm, financial institutions would have to offer yields based on the risk and returns of the underlying assets. Paying out guaranteed returns with new funds from depositors would no longer be allowed.
Commentators at the time described it as “a new era of regulation” which would lead to tighter risk control and slower but higher quality growth in the Chinese economy, blah, blah. However, our interest was piqued by the implementation date for the new rules. This is slated for the end of June 2019, providing Chinese banks and the entire shadow banking system a grade period to get their house in order. As we suggested.
We can only guess the delay reflects the enormity of the problems discovered by China’s regulators when they finally looked under the hood.
We didn’t have to wait long for confirmation that our cynicism was justified. It turns out that there was a “closed-door meeting” last week during which Chinese banks laid out the systemic risk if the regulators pursue their reform plan. According to Reuters.
Ten Chinese banks have raised strong objections to the central bank’s recent move to tighten rules on the asset management sector, saying it may cause a rush of redemptions among other risks, three sources with knowledge of the matter told Reuters.
Senior executives from the joint-stock banks said during a closed-door meeting in Shanghai last week that the rules would have a big impact on financial markets and could even “trigger systemic financial risks”, according to the sources, who declined to be identified due to the sensitivity of the matter. The executives also said the new rules on removing implicit guarantees for wealth management products (WMPs) could spark liquidity risks and increase market volatility, the sources said late on Thursday.
Unlike the Big Four state-owned banks, the smaller banks have limited scope to increase lending in the absence of WMP funding...and that's ignoring the "black holes" hidden beneath the surface.
In short, the entire Chinese financial system, from depositors to banks to asset management companies, has become addicted to the WPM model. Reforming it will only advance the crystallization of losses and bankruptcies, never mind largescale protests from investors who have always assumed that, somehow, the banks would make good on their promises. On a small scale, the clearest example of the near-impossibility of reforming WMPs without threatening China’s financial system, was the example of Foresea Life Insurance in May this year. This report from Fortune captured Ponzi nature and risk of civil unrest.
A Chinese insurer has warned the country’s regulators of defaults in the billions and possible unrest unless it is allowed to launch new products again. Foresea Life Insurance asked the China Insurance Regulatory Commission (CIRC) in a letter dated Apr. 28 to lift its ban, “in order to avoid inciting mass incidents by clients and localized and systemic risks, producing greater damage to the industry,” reports the Financial Times. It further warned that, with an expected redemption of $8.7 billion this year, the insurer might not be able to meet payouts without selling new products.
The Bloomberg article portrays the feedback they gave to regulators on the new regime as “a rare protest by Chinese bankers as pressure mounts amid a government campaign to de-leverage and de-risk the country’s massive and increasingly complex financial system”. However, it’s much more than that, it’s essentially a plea for the survival on the part of smaller banks. Without large pools of deposits, smaller banks have relied on WMP and other shadow banking conduits for funding. In the absence of guaranteed returns, leverage and fraud, that might not have been a problem.
The new rules will pose a direct challenge to a business model that small- and mid-tier banks have been relying on to drive asset expansion and profit growth, bankers told Reuters earlier. “Every time when the regulators announce tighter regulations it would almost always benefit the large state banks and hurt the smaller ones, because they (the latter) are taking much bigger risks,” said a senior executive at one of the country’s big four state-controlled lenders.
The joint-stock banks, which are unable to compete against large state banks for public deposits, have depended on selling WMPs with implicit guarantee of fixed returns to attract retail funds. In turn, they invest the money they manage into stocks, bonds and non-standard debt assets to generate profit. Bank executives said at the meeting the 28.38 trillion yuan of banks’ WMPs, part of the so-called shadow banking sector, have allowed them to bypass regulatory restrictions on credit expansion and capital constraints.
The problem for Xi Jinping and his cronies is that they left the situation to fester for way too long before attempting to intervene. In an effort to dissuade the authorities, here is Reuters on more warnings from the threatened banks.
If the current draft of the rules takes effect, banks will be forced to offload assets beforehand, including selling bonds, stocks and other liquid assets at a discount and asking clients to repay loans before time, the sources said. “No matter which solution we choose, it will hit financial markets,” they added.
The banks also said rules on strictly limiting bank WMP investments in non-standard debt assets and private equities would reduce their support for the real economy and increase financing costs for companies, the sources said. They also suggested the central bank remove certain rules and extend the transition period for the new rules - currently up to June 2019 - to three years to smooth the impact, the sources said.
…which basically amounts to a “Catch-22” situation for China’s financial system.
Meanwhile, it’s worth highlighting a (very) recent example of fraud in the Chinese banking system which encompassed the WMP sector. Last Friday, the South China Morning Post (SCMP) reported on the 722 million yuan ($109 million) fine – the industry’s biggest penalty - served on Guangfa Bank, the largest bank in Guangzhou city. The bank covered up the default of two bonds issued by phone maker, Cosun Group, which had ben sold on an Ant Financial Holdings’ WMP platform. As the SCMP explains.
Ant Financial and 10 other banks sought compensation for investors from Zheshang Property and Casualty Insurance, which had provided insurance coverage on the debt, only to discover that the insurer had been issued fake letters of guarantee by Guangfa’s branch in Huizhou city. The fraudulent documents were created using counterfeit corporate seals made by branch staff. The case involved as much as 12 billion yuan, as the bank tried to channel money to cover its mounting bad loans and operational losses.
“Guangfa did everything that regulators hate the most,” said Chen Shujin, chief financial analyst at Huatai Securities. “They gave an under-the-table guarantee, and made illegal interbank investments to cover up a non-performing loan.”
The epidemic of fraud across China’s financial system has been obvious for years. The Catch-22 situation faced by the Chinese authorities boils down to a timing preference. With Xi’s position cemented for the next five years, the authorities can bring on the “Minsky moment” adjustment, knowing that the economy can recover by 2022. Or they can postpone it, leading to a truly catastrophic collapse down the road.