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Special Situations

Proposed Asset Management Rules Will Help Tame China’s Shadow Banking Problem

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China’s new rules on asset management products will help address the country’s loosely regulated shadow banking system by better managing the growth of banks’ US$4.4 trillion wealth management products, market participants say.

The People’s Bank of China together with other financial regulators released a comprehensive consultation document for financial institutions on November 17, setting new guidelines on the asset management business. The rules tighten controls over wealth management products, such as prohibiting financial institutions from selling investment products with guaranteed returns.

“We see the wealth management regulatory initiative as a positive development for China’s financial stability in the long run,” Qiang Liao, credit analyst at S&P Global Ratings wrote in a note. “This is because the proposed rules close regulatory loopholes that allow banks to underestimate the potential capital impact of the wealth management business.”

The collective outstanding volume of China’s asset management business reached RMB116.2 trillion (US$16.9 trillion), including RMB29 trillion (US$4.4 trillion) from the banks, at the end of 2016, according to China’s central bank.

Under the proposed rules, banks can no longer offer wealth management products with a guaranteed rate of return. The value of wealth management products with guaranteed returns has reportedly reached RMB7 trillion (US$1.1 trillion), or about a quarter of banks’ total wealth management products.

“We think this new regulation could be a game-changer. If Chinese banks are required to recognize the risk of implicit guarantees on wealth management products, they will have less incentive to issue ‘expected-return-based’ products. Moreover, if the risks are clearer and the backstops removed, customers will have less incentive to invest in these types of wealth management products, a mainstay of China’s shadow banking space,” wrote Liao.

Wealth management products have traditionally been handled by banks’ asset management divisions. But regulators propose that banks separate out such divisions as subsidiaries which operate independently. The move is seen as another way to compel banks provide products that properly reflect the underlying institution’s risks and abilities to generate returns.

“Many retail investors choose a banks’ wealth management products because they buy the credit of banks. But banks’ new asset management subsidies will not have the same credit as they don’t have the financial muscle to guarantee the principal or rates of return,” said Yin Ge, partner at Han Kun Law Offices.

Also, the proposed rules ban financial institutions from “channeling” each other’s asset management products. In the past, securities firms and trusts provided channels for banks to invest in their products, which are in effect loans that are structured to appear as holdings of investment products issued by a third party.

In terms of product structure, asset management products can now only invest in one layer of other products, which will prevent systematic risks.

“For example, asset managers used to use subscription money of product A to invest in product B, and further use subscription of product B to invest in another product down the chain, expanding asset under management indirectly,” said Ge. “It is difficult for investors of product A to understand the underlying assets to access their risks.”

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