Regulating those Chinese Weapons of Mass Ponzi

Remember WMPs? The touchstones of China’s shadow market? The shadow market that China might actually be cracking down on… like for real this time…

According to Credit Suisse, new regulatory guidelines or consultation papers about new regulations have been announced on almost a bi-weekly basis since May:

But since it’s too soon to know if that means China is tightening overall or not (more in the usual place on the “yes it is” side) we may as well look at a piece of this… the aforementioned WMPS, where, as Stephen Green, then of StanChart, said “China’s new middle class is meeting interest rate liberalisation, and so far households like what they see”. (That’s so far our favourite way of describing what drove their growth, and their risks.)

WMPS are at number 6 in the list of recent regulations above. Do click to enlarge.

They’re especially concerning because the off balance sheet versions (RMB21tn of RMB26.4tn, or lots if you will) represent some 16 per cent of Chinese commercial banks’ total assets, according to CreditSights, and because investors think that banks will stand behind them.

Put those two things together and you get the potential for a lot of messiness if things start to go south. How big those losses might be is fuzzy.

So in an apparent effort to contain risk we get an extended, oft collated and already mentioned, regulatory effort.

This is all still technically in draft form (updated from a previous draft form in 2014) but it makes for a pretty detailed map of regulatory concerns. This list (and truncated explanations) are brought to you by CreditSights’ Matthew Phan:

1. “Restrictions on WMP leverage: Leverage at any single WMP is limited by an assets ­to­ net­ assets ratio of 140%. This is the same as in the previous 2014 draft.” As CreditSights say, banks aren’t actually forthcoming on the leverage they are running with but returns have dropped suggesting “banks have allowed WMP returns to fall, rather than use leverage to prop them up at unrealistic levels. However, a small proportion of WMPs continue to promise high returns, and anecdotal warnings continue to abound. “
2. “Restrictions on risk tranching: Banks are barred from issuing WMPs in different tranches, such as senior and subordinated tranches, with the latter taking on the first loss. This is a significant turnaround from the 2014 draft which explicitly allowed for tranching of risk and returns in WMPs.”
3. “Restrictions on WMP duration mismatch: For WMPs invested in non­standard assets, the maturity of underlying assets cannot be longer than the maturity of the WMP itself, in order to prevent asset liability duration mismatch leading to liquidity risks. The restriction was also included in the 2014 draft and applied to WMPs invested in project finance.”
4. “Restrictions on investments by investor type: WMPs are barred from directly or indirectly investing in the issuing bank’s own loans or other credit or ‘rights’ type assets. If issued to natural persons (i.e. non institutional investors), WMPs cannot invest in any banks’ non­performing assets (although the regulator may grant exceptions). WMPs issued to retail investors are not allowed to invest in assets other than money market instruments and bond market securities. This is unless the WMPs are issued to private banking clients, high net worth individuals or institutional investors”
5. Restriction on non­standard assets: In place since 2013 this means that “WMPs are not allowed to invest more than 35% of funds into ‘non­standard assets’. This applies to the issuing bank’s entire WMP portfolio as well as for any individual WMP. The investment in ‘non­standard’ assets also cannot rise above 4% of the issuing bank’s total balance sheet assets. “
6. Restriction on investing in intermediate fund structures: “For WMPs that invest in other fund structures – such as trust products or securities or insurance firms’ asset management plans ­ the intermediate vehicle cannot then invest in non­standard products. This is with the exception of trust products that comply with existing regulations governing cooperation between banks and trust companies.”
7. Provision and capital requirements: “Banks must accrue general loss allowances or reserves against their WMP portfolios of at least 1% of total outstanding WMPs. Banks are to build up these loss reserves by making provisions against WMP issuance… Separately, banks are also required to have at least RMB 5 bn of capital in order to issue more sophisticated WMPs (those allowed to invest in non­standard products). Neither the rules on provisions or capital are new, but they have not been implemented and are worth pointing out.”
8. “Requirement for 3rd party custody: Banks must use 3rd ­party custodians and are barred from serving as custodian for their own WMPs. According to Caixin, this will be a big change from the current practice where most banks are custodians for their own WMP assets.”

Meanwhile Jason Bedford at UBS, when writing about Document 82 (which was more about regulated NPL transfers but has real and obvious overlap), continues “to believe that market concerns around bank WMPs may be excessive” and is, you would think counterintuitively, “still much more concerned about the on-balance sheet shadow loans than the off-balance sheet ones.”

According to him, if some of these assets need to be brought back on-balance sheet, and provisioned and recognised accordingly… “Subject to how big such off-balance sheet positions are, we estimate this could result in additional capital needs of up to Rmb438bn.”

Overall though, the effect of the list above should ease fears of a run on WMPs (particularly where the duration mismatching was concerned) and lower returns.

But there are worries, say CreditSights, such as whether banks look to get around rules on investment type by colluding “to purchase other banks’ loans (possibly with implicit guarantees from the selling bank)”.

There’s also some concerns “about WMPs sold to other WMPs, or ‘WMP­squared‘, an allusion to the ‘CDO­squared’ structures that led to huge losses in the US financial system in 2008­”.

They’d go WMP^2 to get around the cap of 35 per cent on investment of funds into “non-standard assets” — defined by CreditSights “as any assets not traded in the interbank market or on an exchange.”

The tricky bit happens when one WMP invests in another WMP. Then even if that second vehicle invests in “non-standards” the first WMP apparently doesn’t have to disclose it. The guess though is that WMPsquareds aren’t yet a big problem even if their rate of growth is impressive. We should note too that corporate bonds aren’t considered nonstandard, even if the issuer has obtained a shadow loan.

Of course, two classic question about China’s shadow banking sector remains.

One as flagged by BofAML’s Cui and Bloomberg’s Tracy Alloway is: what will this attempt to slow the shadow banking sector due to assets more generally? Property for example has more than a toe in the shadow pool. But, and as already mentioned, it’s really hard to know just yet whether what looks like an overall policy tightening is actually real. Or, even if it is real, if it will be maintained. Again, more in the usual place on that.

Related links:
LGFV credit risk and the rate wall of China – FT Alphaville
Bank acceptance bills, newspapers and fraud in China – FT Alphaville
In defence of China’s shadow banks – FT Alphaville
Chinese State Fund Taps WMPs in Financing Shift, Merchants Says – Bloomberg