Commercial banks in China are masking true levels of exposure to wealth management products (WMP) due to outdated regulations in the country. In order to mitigate the risks for banks, Beijing must introduce interest rate liberalisation as soon as possible, as well as reducing product fees and reconsidering reserve requirement and loan-to-deposit ratios, say commentators.
The calls come following a police investigation into wealth management products sold by former employees of Huaxia Bank. The event has led analysts to suggest that China’s banking sector is at risk due to high and rising levels of WMPs that add opacity to the sector.
In addition, others have argued that further instances of misconduct are likely, which could lead to refinancing risks due to asset-liability mismatches combined with the reputational damage that would arise from more default cases.
The figures are far from exact, but it is estimated that the total volume of WMPs in China’s banking system will have risen from Rmb8.5 trillion (US$1.37 trillion) at the end of last year, to Rmb13 trillion by the end of 2012, according to Fitch Ratings. The top five issuers are China Construction Bank, Bank of China, China Merchant Bank, Industrial and Commercial Bank of China and Bank of Communications.
Commentators argue that far from being the fault of the banks, rising levels of WMPs are due in large part to outmoded regulations which, if left unaddressed, will cause the unregulated sector to continue to spiral larger. As such, regulators need to re-assess rules for commercial banks and bring WMPs back into the domain of transparency, according to Li-Gang Liu, chief economist for greater China at ANZ.
“Large off-balance activities will make China’s commercial banks become more speculative, thus destabilising the overall banking system [but] one natural question to ask is why China’s commercial banks do not include WMPs on their balance sheets,” he said.
The key reason for this is the country’s tightly regulated interest rates. Increasing deposit outflows have spurred banks to offer WMPs with higher deposit rates than the benchmark ceiling, in order to keep deposits within the system.
In essence, WMPs are a means through which the country’s lenders compete with non-banking financial institutions for a share of deposits. As such, banks cannot disclose these liabilities due to possible compliance risks.
Furthermore, Chinese commercial banks must comply with a 75% loan-to-deposit ratio as well as a reserve requirement ratio of 20%. As such, banks tend to want to reduce the size of deposits on their books in order to maximise returns. Finally, many of the country’s banks must comply with a loan quota, but any assets not recorded on their balance sheets are not subject to this quota.
Regulatory reform
“The constant strain on banks to satisfy their clients' demand for credit and arguably outdated regulatory funding and liquidity requirements have driven many banks to hide their credit exposure through wealth management products or other shadow banking channels,” said Qiang Liao, director of financial institutions ratings at Standard & Poor’s (S&P).
However, while the removal of interest rate regulations and lowering of over conservative liquidity ratios should remove a majority of the incentives for banks to offer WMPs to the market, it would not do away with all of them, he said.
“The banks also engage in these activities in order to hide higher credit risks from their balance sheets, so the local regulator needs to find some other measures to deal with this.”
Another factor spurring the surge of WMP issuance as well as informal lending, is the country’s underdeveloped financial markets. Due to a supply and demand mismatch, many of the financially weaker borrowers are crowded out from the regulated loan markets.
In addition, he argued that more liberal capital market regulations are essential. China’s caution on corporate bond defaults is yield incentivised, he said, but this approach is thwarting market development.
“They are working to solve the problem but the pace is too slow. Because of these issues in the next few quarters you will see increasing numbers of defaults in the grey markets that will continue to make headlines. If the banks have to take on the fallout from any default in this market, it could elevate credit losses at the banks and undermine confidence in some of the worst-hit smaller banks.”
“There are a lot of financial risks in this sector and down the road there will be default cases coming. This has caused some concerns among regulators, so in the first half of next year the government will probably tighten control on the overall shadow banking business,” said Zhiwei Zhang, China chief economist at Nomura.
The government is looking to test reform in selected areas of the system, but reform needs to take place across the board, in order to avoid distortions, according to Liu. The Wenzhou financial reform plans are a step in the right direction, but not a large enough step.
“While these local experiments are encouraging, it is difficult to rely on local experiments for overall financial sector reform. After all, local financial experiments also create distortions and funds will flow to areas that can offer the highest returns,” he said.
“Therefore, China will also need to focus on comprehensive and sweeping reforms in the near future in order to fundamentally contain the risks of shadow banking activities.”