China regulator drafts new rules to tame shadow banking

China regulator drafts new rules to tame shadow banking

Thu, Nov 21 2013

* Banks use complex deal structures to evade lending curbs

* Risky corporate credit disguised as interbank loans

* Trust firms used for loans to real estate, local govts

* Rules target use of secret “drawer agreement” guarantees

By Hongmei Zhao and Gabriel Wildau

SHANGHAI, Nov 22 (Reuters) – China’s financial regulators are preparing new rules to crack down on explosive growth in complex interbank transactions used to evade lending restrictions, senior bankers who have seen drafts of the regulations told Reuters this week. The measures, likely to be put in place early next year, aim to curb excess credit growth to prevent a debt crisis as China’s economy slows. Despite a string of new rules earlier this year, banks have found ways to expand credit through shadow-banking channels that have raised concerns over the potential for systemic risk.Fitch estimates that the economy-wide debt-to-GDP ratio will reach 218 percent of GDP by the end of 2013, up 87 percentage points since 2008. In July, the IMF warned similarly rapid debt run-ups have been associated with financial crises in other countries.

In June, the central bank engineered a severe cash crunch that forced short-term lending rates to historic highs. Bankers interpreted the short, sharp shock as a warning to reduce risky shadow banking activity.

Rules on capital adequacy and loan-to-deposit ratios (LDR) should limit the amount of loans that Chinese banks can make to firms and households.

But banks circumvent those limits by disguising such credit as loans to other banks, which require less capital and don’t count towards the LDR.

“Growth in interbank exposures has increased the risk of the banks – particularly small and mid-sized banks,” Michael Werner, China banks analyst at Bernstein Research in Hong Kong, wrote in a Nov. 14 note to clients.

Among listed banks, Werner said those whose transactions were under most scrutiny included China Merchants Bank , Industrial Bank, Minsheng Bank , Ping An Bank. They could be most affected by the new rules.

In its latest quarterly monetary policy report, the People’s Bank of China (PBOC) devoted two pages to analysing the rapid rise of interbank business, the first time it has ever discussed the topic in such detail.

“Some commercial banks … exploit interbank business to launch loan-equivalent financing or to falsely increase deposit volumes, increasing the difficulty of liquidity management and risk control,” the bank said in the report released on Tuesday.

“This has compromised the effectiveness of macro-economic and financial regulation.”

HALTING THE MERRY-GO-ROUND

The pending rules from the China Banking Regulatory Commission ban specific commonly-used transaction structures, said a source close to regulators.

Among the banned structures are tri-party transactions involving trust companies. Trusts are non-bank financial institutions that sell high-yielding investment products and use the proceeds to make loans to risky borrowers.

Trust lending has grown rapidly in recent years and is now the largest source of non-bank credit in China’s financial system. Trust loans accounted for 11 percent of total corporate fundraising through October this year, official data shows, up from only 2 percent in 2011.

Many trust loans flow to sectors which regulators have told banks to reduce lending to, notably local governments and real estate developers.

In one typical interbank lending pattern, Bank A purchases a trust product issued by a trust company, then sells a so-called “trust beneficiary rights” to Bank B.

The beneficiary rights grant Bank B the right to income from the trust product, even as Bank A technically maintains ownership. This allows Bank B to record the beneficiary rights as an interbank asset, so the bank can hold less capital than if it purchased the product outright. (GRAPHIC-The alchemy behind ‘trust beneficiary rights: link.reuters.com/hum24v)

Crucially, the new rules also ban so-called “drawer agreements” in which Bank B or another institution secretly guarantees its counterparty against losses on a trust product or other underlying asset.

Such agreements — named for the fact that they are not publicly disclosed — transfer the risk of default on the underlying loan to Bank B or another guarantor, even as Bank A remains the ostensible owner of the asset.

In such a transaction, Bank B is the ultimate source of funding for the trust loan. Such banks typically have access to funds but limited space to expand their balance sheets without exceeding regulatory ratios. By contrast, Bank A typically has less access to funding but more space to expand its balance sheet.

In a bid to reduce liquidity risk stemming from maturity mismatch between long-dated assets and short-dated liabilities, the rules limit most interbank loans to no more than one year. They also state that a bank’s exposure to a single counterparty in the interbank market cannot exceed 50 percent of the bank’s tier-one capital.

“While new banking regulations and reforms are likely to improve the competitive positions of the mid-sized banks in the longer-term, in the short-term we expect regulations to hurt the joint-stock banks,” wrote Werner, referring to mid-sized lenders. (Editing by Simon Cameron-Moore)

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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