Beijing wants to bring some of China’s shadowy credit markets into the light. And it’s prepared to use instruments that were until recently considered taboo to do so.
On September 16, People’s Bank of China (PBoC) governor Zhou Xiaochuan wrote in Seeking Truth magazine that more needs to be done to make securitisation a standard practice in the country’s domestic capital markets.
It’s a marked shift in tone from less than five years ago, when the travails of banks that bought into US sub-prime mortgage products caused the global financial crisis. Along with many other nations, Beijing effectively closed the door on securitisation products. Yet now they are seen as an important catalyst for funding in a country needing to improve credit-market transparency and transfer risk away from its banks.
The groundwork for a securitisation market already exists. The PBoC reopened the government’s Credit Asset Securitisation (CAS) programme last year, and on September 19 the Agricultural Development Bank of China became the second policy bank to use it, with a Rmb1.27 billion (US$208.44 million) deal backed by 42 performing corporate loans from 36 borrowers.
The Chinese Securities Regulatory Commission (CSRC) is pushing securitisation too, having in March upgraded its regulatory framework to make securitised products more routine. Orient Asset Management – one of China’s four asset management companies – took advantage of this to conduct a microloan-based asset-backed security issue for Alibaba Group on July 29. A total of 17 separate-account asset-management plans (SAMPs) with aggregate assets of more than Rmb35 billion had been approved by that month.
More is set to come. Premier Li Keqiang said in a State Council meeting in August that the government would look to increase the CAS programme quota to Rmb300 billion by mid-2014 and take further steps to boost market liquidity, broaden the investor base and enhance regulatory controls.
These new steps are the result of a tacit acceptance by Beijing’s leaders that the country’s financial system, while growing rapidly, is not doing so efficiently or transparently. Banks are too unwilling to lend to non-state affiliated companies, the equity market is volatile and prone to capital flight, and the bond market too nascent.
Little wonder that companies and local governments alike routinely turn to trust companies and private lenders for money.
Promoting securitisation and enabling banks to spin off their assets are some encouraging developments, but it’s very early days. If securitisation is to become a mainstream funding option, Beijing needs to expand and more fully implement these plans along with introducing some vital market reforms.
Shadow banking fears
Ostensibly, the CAS programme was renewed to help banks overcome credit constraints by transferring credit risks off balance sheet to capital market investors.
But there’s another reason for its return: China’s financial regulators want to incentivise banks and non-banks to reduce off-balance-sheet lending to unregulated, opaque and potentially systemically risky credit markets – activities better known as shadow banking.
There are two particular areas of concern in shadow banking: wealth management products (WMPs), and bank-related trust companies conducting off-balance-sheet loans to the local government sector.
WMPs mostly consist of a set of loans repackaged into high-yielding, short-dated products that are sold to retail investors, often via trust companies. These informally created relatively unregulated products bear more than a passing resemblance to collateralised debt obligations (CDOs), a form of securitisation that fell out of favour in most markets after the global financial crisis.
Most WMPs are fairly safe. The China Banking Regulatory Commission (CBRC) says that 60% of them are invested in money-market funds and/or bonds. But the remaining 40%, roughly Rmb3 trillion-worth, are backed by medium- and long-term loans made to small- and medium-sized enterprises (SMEs), real-estate companies and local governments. All are relatively risky borrowers.
Banks like WMPs because they help them attract retail funding outside of their regulated deposit-taking businesses. They can be used to shift assets and liabilities on and off balance sheet, helping the lenders avoid reserve requirements that can otherwise spiral up to 20%. The products offer investors very high rates of return compared to standard deposits, and as a result their issuance has rapidly grown.
According to data provided by the CBRC, bank-issued WMPs grew by 55% between 2011 and 2012. Total outstandings stood at Rmb7.1 trillion by the end of last year.
But many economists worry about the instruments’ lack of transparency and the health of the underlying borrowers.
“We know that the bulk of local government spending has been funded by shadow banking since the government imposed limits on bank credit,” says Chi Lo, senior strategist for Greater China with BNP Paribas. “This is why Beijing is getting concerned about the long-term risks and looking for ways to refinance those risks.”
Secure solution
In contrast, a regulated and public securitisation market promises far greater transparency.
Securitisation involves bank or non-bank lenders placing some of their corporate or local government loans into a separate special-purpose vehicle (SPV), which pays for the assets by issuing debt to investors. This shifts the asset risk to these investors.
Provided they are subject to sufficient risk disclosure, the products would help the central bank, regulators and investors better understand where industry risks reside, and their cost.
China’s original interbank securitisation programme, launched in 2005, encompassed infrastructure loans, auto loans, affordable housing construction loans and SME loans. However, securitised deals required mandatory credit ratings from at least two agencies, issuers had to retain at least 5% of the riskiest tranche of securities, and single investors were restricted from buying more than 40% of any deal.
The government believes that securitisation products offer lenders a means to free up balance sheet through relatively safe products. Jerome Cheng, vice-president and senior credit officer with Moody’s structured finance group in Hong Kong, says that deals in the pipeline are mostly based on corporate assets. These are not banks’ best-quality assets, but are deemed safer than local government loans.
Li-Gang Liu, chief economist, Greater China, with ANZ in Hong Kong, believes the capital markets’ investor demand for exposure to weaker loans, coupled with the transparency of the process, means that securitised products could encompass the latter too.
“I expect Chinese banks to hold on to the relatively safe assets like residential mortgages as the housing market is still moving up at a fast pace,” he says. “There is a strong possibility, however, that banks will look to securitise some of their bad loans associated with local government infrastructure. This would be no bad thing as investors would be fully aware of the risks they are buying.”
Certainly, securitised products are designed to absorb a certain level of losses or defaults among the underlying assets when they are properly structured. And the process of assessing, structuring and pricing such debt would shed more light on the strength of the Chinese banking system.
Many bankers think securitisation can help China’s burgeoning capital market play a bigger role in a credit space currently dominated by state-owned banks.
“Securitisation should be part of the solution that allows the whole Chinese system to move away from implicit guarantee of everyone [by the government] to market-based risk pricing,” says BNP’s Lo.
Micro-loan risk transferred
At the same time as the CAS framework returns to life, securities companies are seeking to initiate corporate asset securitisation in the SAMP market.
In June, Orient Asset Management received CSRC approval for China’s first micro-loan securitisation by a securities firm, in a sign of the potential of securitised products to loosen the hold of the shadow-banking market on such lending. Indeed, micro-lending by non-banks currently accounts for 19% of shadow-banking activities, according to Deutsche Bank. Structured in partnership with China’s e-commerce giant Alibaba, the assets underlying the deal are unsecured microloans to micro enterprises and sole proprietors.
The CSRC approved 10 separate tranches in the Orient deal, which priced on July 29, each with Rmb200 million-Rmb500 million of asset-backed securities maturing in one to two years. The ‘AAA’-rated senior tranches, which offer a yield of 6.2%, will be sold to ordinary investors while the junior tranches will be retained by Orient. Interest rates on the securitised microloans are estimated at 18%-21%, according to Nomura Research Institute.
The CSRC went on to approve 17 securities products from eight securities companies by late July, with a further seven transactions under review, according to Nomura Research Institute analyst Wu Tianjing.
There’s potential for many more such deals. The PBoC estimates that banks provided Rmb600 billion in micro-lending to SMEs in 2012, with more than 6,000 active lenders. Moody’s notes that while micro-lending lacks the transparency and formal regulation of larger corporate loans, banks typically offer the funding to borrowers with whom they are familiar in their local neighbourhoods, helping reduce loan risks.
However, there are difficulties that limit the potential for microfinancing-based securitisation. For a start, microfinance lenders need a sufficient pool of assets. Micro-loans can be taken out and repaid at any time and loan tenors are relatively short, ranging from a few days to several months. As a result, the assets underlying a microfinance securitisation could vary significantly over the life of the deal. Issuers need to continuously replenish the asset pool with loans of sufficient quality and of the right duration to make deals work.
“Alibaba microfinance’s securitisations received CSRC approval presumably because the Alibaba Group is able to manage risk and maintain its credit rating by virtue of its large size and financial strength. Few other companies are able to imitate Alibaba,” Tianjing says. Fellow e-commerce company Baidu could be one. It gained approval to set up a small loan service in September.
Notwithstanding Alibaba’s unique competitive positioning, the deal offers a potential roadmap for future SME securitisations.
“The Alibaba SME CLO illustrates three key credit aspects of SME loan securitisations, all of which are important considerations for the successful emergence of this asset class in China. First, the credit quality of the loans. Second, the loan origination and servicing. Third, the transaction structure. The latter includes early amortisation triggers and eligibility criteria for loan addition during the revolving period,” says Moody’s Cheng. “The Alibaba SME CLO transaction is backed by a large and diversified loan portfolio with good historical performance.”
Early days
The two versions of securitisation offer a lot of potential. But there’s a long way to go before asset-backed securities (ABS) become a mainstream funding option in China.
Just Rmb89.6 billion of outstanding ABS exist, representing 0.1% of total social financing, or total country liquidity including bank loans, non-banking financing and capital-market activities.
“Unless quotas are lifted dramatically, the small scale of China’s securitisation market means any attempt at ‘cleaning up’ the country’s banks by large-scale transfer of NPLs (non-performing loans) could be problematic – given problems with pricing such assets and the potential for overwhelming what is a fledgling market,” says Stan Ho, global chief analyst at Universal Credit Rating Group, a Hong Kong-headquartered international credit rating company.
It will take more than quota increases alone. China’s financial regulators need to solve a set of regulatory issues before a local securitisation market can thrive in the country.
For a start, the market needs to be unified under one regulator. Currently securitised deals arranged under the CAS scheme are placed into the PBoC-overseen interbank market, while SAMP-arranged deals fall under the purview of the CSRC. The two bodies apply different sets of guidelines and approval processes for the respective deals that they oversee.
Lawyers consider the CAS side to largely be an easier framework under which to issue securitisations, but they note that the rules are not full law and that deal approvals tend to require sign-off from several regulators such as the PBoC and CBRC, adding to the time and expense of getting a deal done.
“The CAS pilot rules, which rely on China’s Trust Law, provide a more solid foundation for legal isolation of assets [than the SAMP framework] but that could be improved and upgraded to a permanent legal framework,” says Kingsley Ong, a partner at Eversheds law firm in Hong Kong, which specialises in structured finance. “The current process means each deal has to be approved by the relevant regulatory agencies.”
Additionally, CAS originators are focusing on corporate loans, mortgages and auto loans under the pilot programme. They are unlikely to look at shadow banking-related assets until explicitly mandated to do so.
“The weaker assets are the ones that banks really want to get rid of, but it’s not clear that regulators are ready yet to give the green light,” says Ong.
Lawyers have more concerns about the legal enforceability and bankruptcy-remote status of the SPVs that issue securitised products under the SAMP framework. Lenders use securitised deals to free up balance sheet and reduce risk by shifting some of the loans they have made to a legally separate SPV, after which they have no more responsibility for the transferred assets. But the SAMP framework lacks comprehensive rules around title transfer for various asset types.
“The SAMP framework does not yet have sufficient legal certainty for consumer finance companies to really embrace it in an aggressive fashion,” says Ong. “Because there is some uncertainty around the isolation of the assets, originators currently have to pay for a guarantee from a provider of a certain rating, which acts as a disincentive. This incurs extra cost and prohibits growth.”
Alibaba demonstrated that an SME loan-backed deal using a simple and transparent structure can navigate these obstacles. But it’s something of an exception, boasting a high-profile and trusted brand. A pipeline of deals will only flourish when lenders can be assured that the underlying assets they place into a securitisation are entirely divorced from their balance sheets, and that the investors who buy these assets can properly assess their performance.
“Market practitioners need more legal certainty and policy support from regulators before they start really investing aggressively in China ABS,” says Ong.
Additionally, key parts of the regulatory framework for micro-lending are evolving in China, with comprehensive rules for online micro-lending not yet established. These regulations need to be firmed up before a great deal more micro-loan-based securitisation can emerge.
Beijing has formed a research team comprising representatives from seven regulatory agencies to do exactly that, including the PBoC, CSRC, CBRC, and the Ministry of Public Security. But it’s unclear how long it will take for these ministries and regulators to agree on new rules, let alone implement them.
Lastly, some economists still fear that a credit crisis could emerge, hurting the nascent securitisation market. China will take things slowly.
Rating-agency reassurance
In addition to writing integral regulation, China’s regulators also need to pay attention to the information disclosure of securitised deals. Credit rating agencies will be integral to this.
The local players have something of an advantage here compared to their international peers. Standard & Poor’s (S&P), Moody’s Investor Services and Fitch Ratings continue to have an uneasy relationship with securitisation products, five years after the global financial crisis emerged as a result of subprime mortgage loan defaults on products that had often been rated ‘AAA’ by the agencies. S&P is facing a US$5 billion lawsuit in the US for alleged fraud in the run-up to the crisis.
Local rating agencies Dagong Global Credit, China Chengxin International Credit and China Lianhe may well be able to leverage off the travails of the big-three rating agencies with both domestic and international investors. The Chinese agencies could also benefit from their local market knowledge around underwriting and servicing practices, which are often key to rating securitisations.
“You cannot simply apply the US standard to judge the local originators’ underwriting and collection procedures without meeting those originators on the ground, seeing and understanding why they are doing things differently. In this regard, having local rating analysts on the ground is important and can help increase their sophistication,” says Ho of Universal Credit Rating Group.
Ironically, the domestic agencies have developed their credit methodology models in partnership with their global peers. For example, Dagong developed its rating methodology in consultation with Moody’s, while Chengxin partnered with Fitch Ratings to draw up its methodology.
The local rating agencies also need to work with auditing firms to assuage concerns about the reliability of financial information that they receive. The bankruptcy of US energy company Enron in 2001 and more recently the US subprime scandal offered harsh lessons in the susceptibility of securitisation to abuse. Worryingly, China’s equity market has witnessed several allegations of fraud in companies’ financial disclosures, and international investors remain concerned about corruption.
Foreign investors are unlikely to feel fully comfortable buying locally securitised instruments until the government and its regulators can demonstrate that it has made progress rooting out fraud and implementing policies that prevent it.
Manageable systemic risk
The good news is that there is still time for China’s regulatory agencies to shepherd in a vibrant securitisation market and materially improve information disclosure standards before systemic risks in the finance sector become unacceptably high.
Economists generally agree that even the riskiest activities such as non-standard WMPs, trust loans to local governments and implicit bank guarantees of non-bank products are manageable, given their size relative to China’s GDP.
According to the Financial Stability Board, the US and Eurozone shadow banking markets respectively stood at 153% and 168% of GDP in 2011. China’s non-bank funding market is far smaller. According to Deutsche Bank it is Rmb21 trillion, or 40% of GDP; Citi is most conservative, estimating it at Rmb28.35 trillion, or 54% of GDP. BNP Paribas and Barclays both calculate it to be 49% of GDP. Other banks think it is lower, including UBS (26%-46%), ANZ (29%-33%) and Bank of America Merrill Lynch (28%). However, it is rising rapidly, by whichever estimate is used.
Given that the PBoC has foreign currency reserves amounting to 43% of GDP, it’s unlikely that shadow banking problems will be large enough to severely damage the country’s financial health in the near future – even if a central government audit of local government indebtedness begun in August reveals any unpleasant surprises when results are reported to the State Council in November.
“The risks associated with Chinese shadow banking activities are manageable, and the latest efforts by regulators, including the new CBRC rules on WMPs, will help prevent overheating of the economy and improve the stability of the banking sector,” says Jun Ma, chief economist with Deutsche Bank in Hong Kong.
Even so, it’s good that Beijing has been shaken out of its complacency. The country has relied too long on banks to fund its state businesses and local governments, while seeking to control their risks. That has forced private businesses into the arms of consumer finance companies, and led lenders to package their risks into opaque WMPs. It’s not a healthy practice for the long term.
Fears about the rise of shadow banking have given China’s financial market reformers an excellent reason to push for the diversification of risk via securitisation; they should seize it with both hands.