China’s New Asset Management Rules Tackle Moral Hazard of Implicit Guarantees

New asset management regulations promise to shake up China’s financial sector by targeting the implicit guarantees and associated moral hazard of popular investment vehicles such as wealth management products.

On 27 April China’s central government financial regulators officially launched the “Guidance Opinions Concerning Standardisation of Asset Management Operations by Financial Institutions” (关于规范金融机构资产管理业务的指导意见).

The release of the draft version of the Opinions last November caused trepidation in both the banking and asset management sectors, due to concerns that Beijing’s targeting of the implicit guarantees that undergird many Chinese investment vehicles could compromise financial stability.

Banks in particular raised concerns that the removal of implicit guarantees could create systemic financial risk by stifling the ability of smaller lenders to access funds, given their dependence upon wealth management products (WMP) as  a conduit for capital in the absence of the large-scale depository networks of their established peers.

The asset management sector in China has posted roaring growth in recent years, with data from the Chinese central bank indicating that it exceeded 100 trillion yuan in scope as of the end of 2017.

The balance of bank off-balance sheet WMP was 22.2 trillion yuan, while the balance of entrusted funds under management by trust companies was 21.9 trillion yuan.

Publicly offered funds and privately offered funds accounted for 11.6 trillion yuan and 11.1 trillion yuan in assets, while the asset management plans of securities companies, fund companies and their subsidiaries and insurers accounted for 16.8 trillion yuan, 13.9 trillion yuan and 2.5 trillion yuan respectively.

Despite the strong concerns of the Chinese banking sector, state media is now touting the ability of the new regulations to curb risk in the financial sector by tackling the moral hazard fostered by implicit guarantees.

An opinion piece published by the state-owned Xinhua News Agency entitled “New Financial Institution Asset Management Rules: Bank Wealth Management Products Will No Longer Guarantee Principal or Income” (金融机构资管新规:银行理财今后不再保本保收益) points out that the surging growth of asset management operations has been accompanied by heightened risk due to both laggard regulations  and the widespread perception of implicit guarantees for products.

“The inconsistency between the standards and regulations for different asset management operations has led to frequent regulatory arbitrage,” said the article.”Some products contain multiple nested levels and unclear base levels of risk, while funding pools harbour liquidity risk.

“Implicit guarantees are widespread…forming a shadow banking system with insufficient regulation beyond the official financial system.”

According to Xinhua the targeting of implicit guarantees is one of the keys to reducing risk levels in China’s asset management sector as well as the broader financial system.

“Breaking implicit guarantees is one of the very important contents of these new asset management regulations.

“Implicit guarantees diverge from the intrinsic nature of asset management products…[they] increase the level of risk-free yields, disrupt fund prices, and not only affect the decisive role of the market in resource allocation, but also weaken market discipline and lead to some investors engaging in risky speculation, financial institutions failing to perform due diligence, and severe moral hazard.”

Xinhua points out that while there are no bank WMP’s in China that provide formal guarantees of principal and yield, there is nonetheless the widespread perception amongst retail investors that any financial product sold by a bank enjoys such guarantees.

“If investors hope to protect principal and yield, all that banks can provide are basically deposits and large-denomination certificates of deposit.

“Yet many people on the market are under the misapprehension that as long as it’s a bank product, then there will definitely be protections for principal and interest…the expected yield of WMP’s is significantly higher than the interest on bank deposits, and the corresponding investment risk is definitely higher.”

The new asset management rules are expected to tackle implicit guarantees by multiple means, chief amongst them the requirement that financial institution no longer commit to guarantees for the principal or yields of financial products, or make any form of payment for struggling products.

“In future no financial institution can commit to guarantees for principal or yield, and investors must choose whether or not to bear corresponding risk based on the information on the product and their own actual conditions.”

The new rules will also prompt financial institutions to shift from an expected returns model for WMP’s to a “net value model” that is more akin to an open-ended fund, with returns based on regularly announced net asset value and investors permitted to redeem products at any time.

Categories of Investors

The Guidance Opinions outline two categories of investors  – unspecified members of the public and qualified investors, with the later referring to investors who possess requisite risk identification capabilities and risk capacity.

Individual qualified investors must possess at least two years of investment experience, as well as satisfy one of the following conditions: net household financial assets of at least 3 million yuan, household financial assets of at least 5 million yuan, or average annual income of at least 400 million yuan over the past there years.

Ban on multiple products channelling funds to the same investment

In order to prevent financial institutions from breaching restrictions on investor numbers by establishing multiple asset management products for a single financial undertaking, the Guidance Opinions require that the amount of funds invested by multiple investment products issued by a single financial institution in a single asset not exceed 30 billion yuan, unless approved by the authorities.

Transition period for implementation of the new regulations to last until end of 2020

An official from the Chinese central bank has said that the implementation of the new asset management regulations will “principle involve a transition period, in order to ensure a stable transition.”

The transition period set by the Opinions is from its date of issuance until the end of 2020, during which period any new products must satisfy the stipulations of the Opinions, while financial institutions will also be permitted to issue old products in order to take over from existing products for which assets have not yet matured, for the purpose of maintaing liquidity and market stability.

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