Following defaults, Chinese Banks Cut Back on wealth-management products which grew from close to zero a few years ago to $1.2 trillion has rung alarm bells about growing risks for banks and retail investors

Updated May 27, 2013, 5:53 p.m. ET

Chinese Banks Cut Back on Wealth-Management Products

BEIJING—New rules aimed at reducing risks in China’s financial-services industry have dented the appeal of high-yield alternatives to deposits and threaten to crimp profits for banks.

Bank issuance of wealth-management products—retail investments that offer some of the security of deposit accounts but higher yields—dropped 8.8% in April from March, according to Cnbenefit, a research firm in the city of Chengdu. The average yield edged down to 4.3% in May from 4.4% in March, Cnbenefit said.

A default on a product sold by Huaxia Bank last year fanned concerns over inadequate disclosure and opaque investment structures.

China’s banking regulator introduced strict new rules in March governing where wealth-management products can be invested, how assets are managed, and standards of disclosure to investors. The rules give China’s banks until the end of the year to reduce the share of wealth-management products invested in illiquid assets to 35% of wealth products, or 4% of total assets. If they don’t, they could be forced to make moves that reduce their profitability, such as allocating more capital to back those assets.

The prospect of lower growth in the sector, combined with reduced returns and higher management costs, gives China’s banks with an unpalatable choice: reduce returns to investors and risk losing market share, or keep returns high and accept lower margins.

Smaller banks could be particularly hard hit. Small and medium-size banks collectively have a 60% share of the wealth-management market, and 15% of their products are in breach of the new rules, according to estimates from Bernstein Research.“If you lower your product return too significantly in the market, you won’t sell. So if you want to be in the game, you have to maintain a certain level of return and you may have to accept lower level of margin and profitability,” said Simon Ho, China bank analyst at Citigroup C -0.02% .

The explosion in wealth-management products—which have grown from close to zero a few years ago to 7.1 trillion yuan ($1.2 trillion) at the end of 2012, according to the China Banking Regulatory Commission—has rung alarm bells about growing risks for banks and retail investors. A high-profile default on a product sold by Huaxia Bank Co. 600015.SH +1.41%late last year fanned concerns over inadequate disclosure and opaque investment structures, prompting the new rules from the CBRC.

One consequence: a higher proportion of wealth-management products must be invested in highly liquid money-market and bond-market instruments, which offer lower returns. A sales manager at Bank of China Ltd.601988.SH +0.34% said that made wealth-management products a tougher sell.

“Wealth-management products we issued used to be snapped out before the sales deadline, but now we find it hard to sell them all,” the manager said.

Bank of China’s Beijing branches sold 5.5 billion yuan in wealth-management products in April, down sharply from 14 billion yuan in March, according to a source with direct knowledge of the matter.

China Citic Bank Corp. 601998.SH +0.46% Ltd. has shifted its approach since April, following the regulator’s latest rule, according to a person with direct knowledge of the matter. The bank is issuing fewer wealth-management products invested in illiquid instruments such as loans to investment trusts, and more that are invested in liquid but lower-yielding assets such as bonds and money-market instruments, the person said.

Zhang Qiang, vice president at China Citic Bank, said at a briefing in March that nonstandard investment accounted for 64%, or 151.5 billion yuan, of all wealth-management products at the bank, substantially higher than the 35% limit set by the CBRC.

The new controls come at a time when credit is in ample supply. New loans in China reached 3.5 trillion yuan in the first four months of the year, up 12.9% from a year earlier, according to data from the People’s Bank of China. China’s total social financing, a broader measurement of credit, jumped to 7.9 trillion yuan in the first four months of the year, up from 4.85 trillion yuan a year earlier.

Even so, as banks reduce the share of products devoted to loans, some firms could be left scrambling for credit. Some companies have to seek new financing channels to get funded, said a manager in charge of credit with a Chinese joint-stock bank.

The manager said that despite robust credit growth this year, there is still strong demand, especially from local-government financing platforms and the property sector that have limited access to cheap bank loans.