China Commences Crackdown on Shadow Banking

Central bank official: ‘Tackling reforms is like chewing on a hard bone’

Pedestrians walk past the People's Bank of China on July 8, 2015. Greg Baker/AFP/Getty Images

Chinese regulators introduced major rules on Nov. 17—the scale of which has been compared to the U.S. Dodd-Frank Act—to unify regulations for the asset management industry and curtail shadow banking activities.

The rules are broad-based, covering China’s $15 trillion of asset management products issued by all financial institutions. The regulations—a culmination of sorts for Chinese communist regime leader Xi Jinping’s campaign to rein in financial risks this year—will target off-balance sheet businesses of banks, insurers, and asset management entities such as trusts and mutual funds.

“Asset management product” is a loose term used to describe certain types of high-yielding investments, issued by banks, insurers, or asset management firms, that have gained popularity in recent years among small retail customers seeking greater returns. Chinese investors have poured trillions of yuan into such lightly regulated asset classes, lured by high promised returns and implicit government or institutional guarantees.

Financial institutions have increased leverage and their risk tolerance in recent years to generate high enough returns to fund such asset management products, in turn creating asset bubbles and increasing stock market volatility.

One of the biggest challenges Beijing faced was the various and sometimes discordant regulatory bodies that oversaw China’s sprawling financial sector. Asset management regulations are now unified—the new rules were issued jointly by the People’s Bank of China and the top regulatory bodies overseeing the country’s banking, securities, foreign exchange, and insurance sectors. The new rules are open for public consultation and will go into effect in June 2018.

The Details

Last Friday’s regulations introduce restrictions on the type of clients that financial institutions can serve and the types of products they can market.

For example, the rules will prohibit asset managers from promising guaranteed rates of return to investors, and require issuers to set aside 10 percent of their fees from managing client assets in escrow, to serve as a buffer against losses.

The new super regulator will be able to tackle crosssector risks that previously slipped through the cracks.

The new regulations also cap leverage ratio for investment products. For publicly offered funds, total assets cannot exceed 140 percent of the funds’ net asset value. The same ratio is set at 200 percent for privately offered funds.

Certain riskier financial products can only be sold to qualified investors, or those who have at least 5 million yuan ($750,000) in liquid assets or earn more than 400,000 yuan per year for three years.

The rules will also govern companies that only issue financial products over the internet, which could slow the recent growth of online banks and insurers.

Super Regulator

The Nov. 17 draft regulation was the first issued by the newly created Financial Stability and Development Committee, a super regulator under the direct supervision of the State Council, China’s cabinet.

The committee is headed by Vice Premier Ma Kai, according to a report by Xinhua, the state-controlled media. Its status within the State Council will likely grant the committee more regulatory and enforcement powers than the various state ministries.

The new super regulator will be able to tackle cross-sector risks that previously slipped through the cracks of China’s various sector-specific regulators.

The super regulatory body is necessary because “current regulations and the division of labor among the watchdogs have not kept up with product innovations and the evolution of the market,” according to a report by Caixin Global, a mainland business and financial magazine.

Caixin cited examples of “hybrid” internet and financial products that resided online and escaped the grasp of regulators for years, such as the popular Ezubao peer-to-peer lending platform, which turned out to be a Ponzi scheme, and high-yield notes sold by the notorious Fanya Metal Exchange, which was reported by The Epoch Times in 2015 as sitting “in a regulatory black hole.”

Curbing Shadow Banking

By certain measures, new issuances of asset management products have already slowed to a halt.

For the first time since 2012, the official growth rate of China’s GDP was faster than shadow banking assets in the first six months of 2017 (H1 2017), according to credit ratings agency Moody’s Investors Service.

Asset management products fell to 82.6 percent of GDP at June 30, compared to the recent peak of 86.5 percent as of 2016.

“Chinese shadow banking activity stopped growing in H1 2017 because of a fall in, first, the issuance of higher-risk instruments such as the banks’ wealth management products, and, second, non-bank financial institutions’ asset management plans,” Michael Taylor, a Moody’s managing director and chief credit officer for Asia-Pacific, said in a statement.

Following last month’s 19th National Congress of the Communist Party, financial sector regulations to further rein in shadow banking activities are expected, Moody’s said.

“Tackling reforms is like chewing on a hard bone,” said Xu Zhong, director general of the People’s Bank research bureau, during the 8th Caixin Summit in Beijing on Nov. 16, according to a Caixin report.

“Reform is absolutely not a process where success can be guaranteed. We must take the initiative to break out of our ‘psychological comfort zone,’ and fully recognize and prepare for the difficulties, challenges, and even major risks.”