An academic conference recently held by the Tsinghua PBC School of Finance featured some of China’s brightest academics presenting their latest research on various elements of the rapidly evolving Chinese financial system. A topic that was widely discussed was the situation regarding wealth management products (WMPs)- a relatively shadowy and potentially dangerous and destabilizing part of the Chinese financial system. I will use this piece to summarize my own understanding of the situation with WMPs: how we got here and what does the continual evolution of the WMP space mean for the Chinese financial system.
What are WMPs?
WMPs are as the name implies: products for Chinese households and institutional investors to place their wealth. In many ways, they are not too different from mutual fund products offered to investors in developed markets. However, in the eyes of many Chinese investors, these WMPs are seen as an alternative to traditional bank deposits to store their liquid wealth.
WMPs come in a variety of shape and form: guaranteed versus non-guaranteed; floating rate versus fixed rate; open-ended versus close-ended; equity investments versus fixed-income investments etc. Their heterogeneous nature prevents one from labeling these investment tools as universally good or bad. In many ways, WMPs have been a healthy part of the development of the Chinese financial ecosystem as banks are pressed to compete for deposits and households are given competitive options on where to store their wealth. Yields on WMPs often exceed that of traditional bank deposits making them a very attractive investment alternative (see chart). Given their higher yields, WMPs have grown leap and bounds in the past couple of years from nearly nothing in 2007 to over 23.5T yuan, equivalent of 20% of outstanding deposits, by the end of 2015.
So what is wrong with Chinese WMPs?
WMPs in China have often been associated with ‘shadow-lending’, as much of the capital rising and lending is conducted off-balance sheet and away from the prying eyes of China’s banking regulators, the China Banking Regulatory Commission (CBRC). There are possible sources of danger associated with WMPs that may one day (perhaps soon) lead to a messy financial situation that would likely need government resources to resolve.
- Weak regulatory disclosure
WMPs are issued with prospectus detailing their investment intentions, expected return and maturity. However, outside very generic phrases such as “investments supporting ‘new economy’ or ‘innovation’”, the prospectuses of WMPs are vague and do not present a clear image to investors of the final designation of their funds. Moody’s April 2016 ‘Shadow Banking Monitor’ reveals that much of the WMPs’ assets are invested into financial instruments that are not riskless such as bonds, equity and non-standard debt. Should a major down turn occur in Chinese capital markets, WMP investors may be unpleasantly surprised to find the true designation of their investments.
- Chinese investors believe that WMP investments are ‘implicitly guaranteed’
In a functional capital market, the yield of investment products is a function of their financial risk – the higher the yield, the greater the risk. However, in the eyes of Chinese investors, promises of yield are less correlated with the underlying asset of the WMPs than with the reputation of the issuing institution. Indeed, every bank in China broadcasts the yields of their WMP on a large LED screen outside their branch to attract investors. I personally receive approximately one to two text messages a day from CITIC Bank, where I have my checking account, informing me of the latest yields on their WMPs. Despite the very strong advertising support of these issuing banks, on paper, the issuing bank are not responsible for their WMP’s financial fate. The separation of legal responsibility from the act of selling these WMPs allow the majority of WMPs raised to be held off-balance sheet, therefore, not subjected to many of the CBRC’s banking rules.
The logic for Chinese WMP investors is: ‘if a large and reputable bank issued the WMP, then the issuing bank will always find ways to resolve any issues’. The recent episodes of WMP failures have proven this assumption to be correct. However, as profits of the Chinese banking sector continue to decline, then the capacity for China banks to continue providing this implicit guarantee will be impaired; it is unclear when this breaking point will be. However, one result is likely clear: when the private sector can no longer carry this burden, then it is likely that the public sector will have to come in to restore confidence and prevent further panic.
- WMPs face significant roll-over risk
In many ways, WMPs were a response to the vast stimulus unleased in October 2009 to counter the Global Financial Crisis (GFC). With export earnings in free fall, the Chinese government needed financing to be quickly released to the real economy. This led the Chinese government to tolerate alternative and new forms of financing outside traditional bank loans, which has historically dominated credit creation in China. Much of the funding raised by WMPs undoubtedly went on to finance the country’s infrastructure and real-estate assets that are very long term investments. WMPs are advertised to households as alternatives to bank deposits: liquid, safe but with the added benefit a higher yield. The liquid and safe nature of these tools is their key source of attraction and the reason behind their exponential rise. The majority of WMPs have a maturity period of 3 months or less which makes them a very short and unstable source of financing compared to the long-term assets these WMPs carry.
To provide these appealing characteristics, the managers of these WMPs must be able to continuously roll-over their investments either through raising new capital, borrowing from the interbank market, or liquidating their assets. This process makes liquidity conditions extremely vital for the stability of the entire WMP sector. WMPs have become a significant borrower of overnight deposits to roll-over their assets (see chart) since the sharp fall in yields in the second half of 2015. Should stress emerge in the interbank market (i.e. the June 2013 interbank crisis) this can be a destabilizing event to many WMPs who are now dependent on daily liquidity to refinance their assets.
- WMPs are becoming increasingly complex and interdependent
While still a far cry from the complexity of American asset-backed securities that led to the GFC, Chinese WMPs are increasing in complexity to evade regulations set by the CBRC. Previously, multiple WMPs would pool their funds and invest into a trust company that would allocate the funds to the industries that can deliver the desired returns. Aware of the risk of pooling, in August 2010, the CBRC mandated that WMPs could only invest a maximum of 30% of assets into trust loans. Subsequently, the CBRC introduced further regulation in March 2013 that mandated WMPs could only invest at most 35% of their asset in any type of trust assets. The intention of this regulation was to limit the universe of assets WMPs can hold, hopefully slow down their development, and bring the function of financing back on the balance sheet of the commercial banks. However, the unintended effect of this regulation led to further complexity as WMPs began to increase its interaction with the formal banking system to mask its financing chain. The following is a stylized format presented by Hachem et Song (2016) on how this is conducted:
- An investor buys a WMP issued by Bank A;
- Bank A takes the funds and place it as a deposit into Bank B;
- Bank B takes the funds and invest it into a trust, booking the asset as an ‘investment receivable’ while trust takes the funds and issues a trust-beneficiary right (TBR) to Bank B;
- The trust then takes the funds and deploys it as they see fit. Any return will be channeled back to Bank B. After taking a fee, Bank B will channel the fund back to Bank A and ultimately backed to the original investor.
After multiple rounds of regulations, the results obtained by the CBRC have been a mixture of successes and failures. The successful part of the reform is that regulations have been able to bring most of banks’ WMP exposure back on its balance sheet. By mandating that WMPs can only hold 35% of their total assets with trusts, banks were forced to take their asset exposure back on balance sheet. However, the unsuccessful part of the reform has been in what Rodney Jones from Wigram Capital calls ‘on-balance sheet shadow financing’. On- balance sheet financing is essentially the deliberate mislabeling of a bank’s assets to avoid holding the appropriate amount of capital provision against future loss; the aggregate value of assets is correct but the necessary amount of capital provision is lacking leaving the bank exposed to heighten solvency risks. In this scenario, on-balance sheet financing appeared on the balance sheet of Chinese banks in the form of ‘Claims on other financial corporations’.
As detailed in the following chart, the growth of ‘Claims on other financial corporations’ (many of whom are WMP platforms) has been extremely strong following the first round of regulation in August 2010 and the second round of regulation in March 2013. Despite the very fast pace of total bank asset growth, the growth in ‘Other financial corporations’ has by far outstripped that. Prior to the August 2010 regulation, claims on other financing corporations stood at 2.2% of total banking asset; this rapidly rose afterwards and makes up 11% of total banking assets by May 2016. However, despite the sharp increase in on balance sheet banking assets, according to Jones, significant portions of credit remain unconsolidated. Notwithstanding the success in bringing WMP assets on balance-sheet – albeit at the compromised cost on ‘on-balance sheet shadow financing’ –off-balance sheet financing remains significant.
As a response to the March 2013 regulations, banks brought significant portions of WMP assets on-balance sheet but labeled these new assets as ‘investment receivables’ (IR) as opposed to traditional loans. ‘Investment receivables’ is a broad term that covers complex investment arrangements between banks, WMPs and financial intermediaries: ‘trust beneficiary rights’ (TBR) and ‘directional asset management plans’ (DAMPs) are examples of IR. The unifying characteristics of these IRs are that they involve intermediaries and often receive ‘credit-enhancement’ of from third parties. Due to the convoluted nature of the IRs, the CBRC allows banks to hold much less capital against these asset (at 25% of face value) than compared to traditional vanilla loans (at 100% of face value). By bringing in intermediaries and third party credit enhancement, shadow financing is making the financing chain much longer and more complex with the heighten risk that contagion will spread in unpredictable ways.
Implications for the banking system
In a simpler era, a loan default will impact only the issuing bank. Government officials can intervene, provide liquidity to the problematic bank, and arrange a long-term recapitalization program using state funds to rescue the failing bank: this is a stylized version of what occurred during China’s last round of bank bailout in the late 1990s. However, in the current era with so much financing occurring through ‘on-balance sheet shadow financing’ or even completely off-balance sheet, this way of financing blurs the capacity for regulators to accurately identify the key points of stress and act in a timely manner to prevent contagion. Akin to the GFC where regulators were oblivious to the central role AIG played as guarantor to many troubled assets, the current role played by intermediaries and credit enhancers makes the danger impossible to spot until they erupt.
Going ahead, it is likely that CBRC will through regulation try to control the banks’ exposure and mandate better disclosure for this sector. However, until investors accept the relationship between risk and yield and banks properly addresses WMP risk through adequate provisioning, the problems of capital misallocation and moral hazard will persist. The size and the central role the WMPs play in the Chinese financial system makes it systematically important in its own right. This will not be a machine that Chinese authorities can turn off overnight. With the industrial slowdown impairing the profit and solvency of Chinese banks, it is only a matter of when before the ‘implicit’ guarantee of these products will need to be made ‘explicit’ to prevent a financial panic. By then, the question is who will pick up the tab: will it be the issuing banks that intentionally evaded regulations in pursuit of profit; or will it be regulators that turned a blinded eye to this sector’s astronomical growth in the name of “supporting economic growth”?
 This assumption was proven to be spectacularly wrong when China’s then largest P2P fund, E’Zu Bao, collapsed in early 2016. E’Zu Bao had the image of state backing because of their impressive headquarters, their commercials that would frequently appear on China’s state-run television channels and their logos that were even on some of China’s high-speed trains. When their pyramid scheme collapsed, Chinese investors were cheated out of 50B yuan.
 In this sense there are two type of WMPs: principal guaranteed and unguaranteed. For principal guaranteed WMPs they offer a lower rate of return, are consolidated on the balance sheet of the issuing bank, and behaves similar to deposits of the bank. The majority of outstanding WMPs is unguaranteed and will be the focus of discussion for this post.
 Hachem, Kinda Cheryl, and Zheng Michael Song. “Liquidity Regulation and Unintended Financial Transformation in China.” National Bureau of Economic Research, January 2016. doi:10.3386/w21880.