As discussed here in mid-August, when China reported its latest credit data, for the first time in 9 months China's trillion Shadow Banking Industry - defined as the sum of Trust Loans, Entrusted Loans and Undiscounted Bank Loans - contracted.
These three key components combined resulted in a 64BN yuan drain in credit from China's economy, the first negative print since October, seen by analysts as more evidence that Beijing’s campaign to contain shadow banking and quash risks to the financial system, is starting to bear fruit.
And, as a follow up report from Reuters overnight details, the crackdown against unregulated shadow financing is accelerating, noting that as the flood of unregulated cash swirls through the Chinese economy, Beijing has been taking aim at the trust companies whose unrestrained lending practices are worrying regulators. The trusts, which as we have discussed previously are at the heart of a vast shadow banking industry, are being pressured to step up compliance and background checks, and are being pushed towards greater transparency.
But the fast-growing 20 trillion yuan ($3 trillion) industry, whose lending operations are cloaked behind opaque structures, will be tough to rein in, according to employees at some trusts.
As Reuters details, a regulatory sanction against one trust, Shanghai International Trust, and a legal case against another, National Trust, offer rare insights into the industry, and reveals just how hard it will be to police it.
Shanghai Trust was fined 200,000 yuan for selling a product that violated leverage rules, according to a regulator’s notice in January. Regulators provided no further details about the case. Under these rules, property developers are only allowed to borrow up to three times their existing net assets. According to two people with direct knowledge of the case, an unknown sum was loaned by China Construction Bank through Shanghai Trust to Cinda Asset Management Company. Cinda then invested the cash.
One of the sources said Cinda used the cash to acquire land, a sector rife with speculation that regulators have singled out as a “risky” destination for trust company loans. The source provided no further details.
The case against National Trust, which had revenue of 655 million yuan in 2016, involves wealth management products linked to the steel industry. According tot he Reuters reports, the trust was sued in June this year by eight investors who allege it misrepresented the risks involved in products it sold them and failed to adequately assess the guarantor’s creditworthiness. Like most other shadow products that have made news, the trust skirted restrictions on loans to the steel industry by using the products to raise money to lend to a subsidiary of Bohai Steel Group, according to Tang Chunlin, a lawyer at Yingke Law Firm, who is representing the investors.
The plaintiffs invested different sums in the wealth management products, which National Trust promised would deliver an annual return of over 9 percent. National Trust lent the money collected to a Bohai subsidiary, Tianjin Iron and Steel Group Co, according to documents reviewed by Reuters.
Bohai Steel Group, which is undergoing a state-financed restructuring, has liabilities of around 192 billion yuan.
National Trust has now defaulted on the product, according to Tang and Gongyu Zhou, one of the eight investors, because Tianjin Iron and Steel is unable to pay back its loan.The products were also illegally sold via third-party non-financial institutions, Tang and Zhou said.
In his complaint, Zhou said he invested one million yuan in the product over two years from 2015 through 360caifu.com, an online finance platform. And now that the government has not bailed him out, he is angry.
He also may have to wait a long time before he recovers even a fraction of his investment: despite its eagerness to crack down on shadow debt, the biggest challenge facing regulators is that many trusts employ a baffling array of structures, and funnel money through complex webs of beneficiaries, which makes untangling transactions extremely difficult.
Nine people working at trusts, including the two with knowledge of the Shanghai Trust case, said such complex structures were often deliberately used to sidestep lending restrictions on banks and borrowers.
“Really, only the project manager knows exactly how the money flows,” said a senior employee at one trust firm. The source and others at the trust firms could not be named because they were not allowed to speak to the public.
The shady, no pun intended, practices of the trusts, and the speed at which the industry is growing, have made them a target for Beijing as it tries to keep a lid on risky lending, cool overheated markets and control corporate debt. In April, Deng Zhiyi, head of the CBRC’s trust department, warned of “severe risks” from funds flowing into the real estate, coal and steel sectors through trusts.
The unregulated industry is now roughly a tenth the size of China’s commercial banking sector, and is one of the biggest sources of funding as the following Bloomberg chart shows.
While the companies are overseen by China's financial regulator, the CBRC, they are not held to the same standards as banks. For example, they do not have to meet the same capital adequacy standards. However, as we reported at the time, the CBRC set out in detail in April certain structures that the trusts should not use, such as money-pooling schemes and structuring products to avoid restrictions on leverage.
That was “a signal for financial institutions that from a legal and enforcement perspective, we are entering a stricter period,” said Armstrong Chen, financial compliance partner at King & Wood Mallesons.
Trust firms will also have to start registering the details of their products, identifying the ultimate borrower of funds, this year, said Chen, who is in regular contact with the regulators.
Chen said the requirement would improve transparency, but people at trust firms say it will still be difficult to detect the use of the under-the-table agreements typical of the industry.
The Shanghai Trust case also reflected the tougher line being taken by regulators. The fine would have been negligible for the state-owned company, one of the largest trusts with a total of 3.89 billion yuan in revenue at the end of 2016. But, like in the case of Beijing's crackdown on China's major money-laundering conglomerates like Anbang and HNA, three Reuters sources said that Shanghai Trust was also barred from selling products to insurers for three years, a blow to a company that had made considerable sums selling products to the sector in recent years. One insurer invested as much as 10 billion yuan in just one of its property projects, according to one of the sources.
In any case, should Beijing be successful, the supply - and demand - for Trusts will plunge, as they take on more of the characteristics of China's conventional loans offered by banks.
To be sure, some of the trusts are already responding to the government pressure. Anxin Trust is increasing the number of onsite visits by staff and has doubled its compliance team, a Reuters source said. The trust is also looking at less risky deals – in healthcare, for example, rather than the more volatile property sector.
Despite these changes, the government’s job managing the trusts keeps growing. In the first half of this year, trust loans increased by 1.31 trillion yuan, which compared with 279.2 billion in the period last year, according to central bank figures.
That growth will be a challenge for the regulator, which is already facing staff shortages as it struggles to keep up with a broader official crackdown on financial risk.
Meanwhile, the trusts see more boom times ahead: "the demand for trust loans is increasing," an internal report at a large trust firm in May said. “In the past, state-owned-enterprises would not consider such loans, but are now considering them,” according to the non-public report which was made available to Reuters on the condition the name of the company was not disclosed.
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Finally, even if China manages to crackdown on Shadow Banking there is another problem: as a recent report by Natixis put it perfectly, "when one [credit] door closes [in China], another one opens up." This simply means that as Beijing slams the door shut on Trust and other key shadow debt components, these will be offset by an increased usage in others such as WMPs, NBFIs, Repos, Negotiatable Certificates of Deposit, and money markets. Below are the highlights from the report:
As deleverage becomes a higher level objective (but sometimes conflicting) to the Chinese leadership, banks now face more restrictions from regulators. In any event, this is not the first time they find themselves in the regulatory whirlpool. From the usage of repo agreements to wealth management products (WMPs), and most recently negotiable certificate of deposits (NCDs), banks have been very creative in playing the cat and mouse game in front of evolving regulations.
Flourishing financial innovation has helped China’s leverage process to continue unabated. The deleveraging process has hardly begun. In contrast, liquidity seems to be increasingly scarce, which keeps on lifting the cost of funding. In fact, overnight SHIBOR is at record high since the difficult events in 2015, very close to 3% (Chart 1). One of the key reasons for the liquidity shortage is related to tighter regulatory control from the People's Bank of China (PBoC), in particular stricter Macro Prudential Assessment (MPA). This has hampered the use of WMPs to fund banks’ asset growth. They have already shrunk by 1.6 RMB trillion to 28.4 RMB trillion in May 2017 (Chart 2).
After the PBoC limited the use of WMPs, there are now also more regulations targeted at NCDs, which are short-term, non-collateralized paper with an even higher funding cost than the SHIBOR. This has led to a fall in issuance, but has grown again since June 2017. The underlying reasons could probably be a lack of other options and the regulations are not as tight as they may appear on the surface. In fact, the PBoC’s pressure affects banks very differently. It penalizes banks short of liquidity and benefits those long of liquidity. This simply means that China’s five largest commercial banks (all state-owned) are the winners while the others are the losers.
As liquidity is increasingly expensive, liquidity scarce banks have also developed new ways to bypass regulations through money market funds (MMFs), which have reached 5.86 RMB trillion in a very short period of time. The quick pace of expansion may pose extra liquidity risks especially when three-quarter of the assets have a maturity less than 90 days.
Beyond the – probably unintended – push for financial innovation, the PBoC’s regulatory move is also pushing further the duality of China’s banking system. When small banks are struggling for liquidity, large banks stand to benefit from the regulatory crackdown. The latest 2017 Q2 results have confirmed our expectations that large banks can gain from regulatory arbitrage and risks are rising for smaller banks. In other words, the improvement in bank results is not only due to better economic conditions but also to regulatory arbitrage.
The full Natixis report on why Beijing is unlikely to ever be able to get full control of its non-traditional credit creation can be found at the following link.