Chinese Non-banking financial entities in precarious state

Vinod Kothari, Director | finserv@vinodkothari.com

One of the trust companies defaults; other casualties likely

Chinese financial system is opaque and intriguing, for any outside trying to understand it. Regulatory framework is also mostly spasmodic, and given the fact that Chinese regulators do not follow global institutions or their regulations, Chinese institutions have developed along their own lines.

One of the non-banking financial entities in China is “trust companies”, somewhat similar to private collective investment vehicles or alternative investment funds seen elsewhere. These trust companies mostly invest in activities closely mimicking the lending of banks, while at the same time not being regulated as such. The size of the shadow banking industry in China, better known as “non banking financial intermediaries” (NBFIs) is huge, and is the second largest in the world, next only to the USA. Of the NBFIs, trust companies were estimated to be about USD 4 trillion, and 79% of the trust companies are based out of China, as per data as of end-December, 2021, appearing in the NBFI  report of the Financial Stability Board.

The China Banking and Insurance Regulatory Commission (CBIRC)  issued regulations on trust companies on 20^th March, 2023, which requires trust companies to classify their business into asset management business, asset service business and charitable business. The first one, obviously, is the most important in context. However, this regulation gave a time window of 3 years for the trust companies to align their businesses with the new standards. The 2023 regulations were preceded by those in November 2017, when a new policy was issued by the Chinese authorities to regulate banks and trust corporations, requiring that trust corporations do not provide financial institutions with a conduit service for the purpose of avoiding regulations such as investment or leverage constraints. This policy was followed by a series of guidelines for regulating the asset management businesses of financial institutions that were released jointly in April 2018 by the Chinese authorities.

Did the regulation come a day too late, or was the 3 year time window for implementation of the changes not needed at all, as trust companies have already started facing challenges. A trust company called Zhongrong International Trust suffered a credit event as it failed on its financial obligations earlier in August. The trust has monies of some 150000 investors, totalling to about 230 billion yuan.

The default with Zhongrong is not an isolated one; most of the trust companies have significant exposure in commercial real estate and infrastructure, both of which have been sticky  owing to the prevailing economic situation. As a matter of principle, trust companies, working as fiduciary asset managers, should have only very limited leverage powers, but in absence of clear regulations, Chinese trust companies have been incurring debt.

Regulations forced trust companies to reduce their exposure to real estate; however, this regulation was very easy to circumvent by making investments in bonds backed by the very same real estate.

Banks are also investors in the so-called “entrusted investments”, that is, the units of the trust companies. This is exactly what may instigate contagion risks. Rating agency Fitch mentions that banks also have substantial off-balance sheet exposure in trust companies by their so-called “wealth management products”, which is huge – almost 20% of nominal GDP. The investments out of these wealth management funds include investment in trust companies too.

Even insurance companies have invested in the trust companies.

Are there lessons to learn for financial regulators and supervisors? First, opaque regulations which create windows for regulatory arbitrage are very easily exploited. Look-alikes of loan and investment products, giving fixed rates of return, are sold by practitioners. Secondly, the spectre of more than reasonable returns has always been behind any financial crisis. The trust companies in China, for instance, were 6.6% as compared to a 1.5% rate of return on bank deposits. Whenever supervisors see such unreasonable promises, red flags should have gone up. Third, exposures in commercial real estate, direct as well as indirect, must always be watched. Regulators commonly have a separate reporting requirement for these exposures, but it should not be possible to circumvent the same by structuring the same as bonds or similar investment products.