A Major Threat to China’s Banks

China's authorities are growing increasingly worried about major risks to the nation's economy and financial system.

Of particular concern is Chinese banks' exposure to wealth management products, or WMPs -- short-term investments that account for a significant portion of banks' balance sheets and may carry hidden risks far greater than previously thought.

Let's take a closer look at these financial products, the major risks they pose to China's banks, and what China's authorities are doing to stem these risks.

A primer on China's wealth management products
WMPs are essentially short-term investments sold by Chinese banks that serve as an attractive alternative to bank deposits. In recent years, their issuance has skyrocketed. According to China's banking regulator, the China Banking Regulatory Commission (CBRC), 7.1 trillion yuan worth of WMPs were outstanding as of year-end 2012, equivalent to 7.4% of bank deposits.  

WMPs have been the most obvious and commonly sought after solution for Chinese savers in search of higher returns. On average, they yield roughly 2% higher than bank deposits, yet are marketed as low-risk investments. Several sources have identified WMPs' structure -- which involves pooling investor funds together and using that pool to invest in a variety of assets, some highly risky and some less so -- as a major cause for concern. 

Major risks associated with WMPs
WMPs tend to have short maturities, generally less than a year. But in many cases, the funds pooled together from WMP sales have been invested in much longer-term projects, usually related to property and infrastructure, which creates what's known as a maturity mismatch issue.

In order to subdue this inherent problem, banks are forced to keep issuing new WMPs to replace expiring ones. If that doesn't smack of Ponzi finance, I don't know what does.

Another major issue related to WMPs is their lack of transparency. Because they involve the pooling of several investor funds, which are then invested in a wide range of projects that traverse the risk spectrum, it is extremely difficult to estimate the risk of any single WMP.  

Remember collateralized debt obligations (CDOs) from a few years ago? Like WMPs, one of the key issues with these complex, asset-backed securities was their lack of transparency. Because they had multiple "tranches" that offered varying risk-return profiles, and because many of them invested primarily in other CDOs, they proved extremely difficult to value. 

Failure to appropriately gauge their risk even brought down insurance giant AIG (NYSE: AIG  ) , which had insured $62.1 billion in CDOs when it was bailed out by the U.S. government in 2008. The CDOs it insured were underwritten by some of the world's premier financial institutions, including Merrill Lynch & Co., now part of Bank of America (NYSE: BAC  ) , which underwrote $13.2 billion, Deutsche Bank AG, responsible for $9.5 billion, and Goldman Sachs (NYSE: GS  ) , which underwrote $17.2 billion worth of CDOs insured by AIG -- more than any other financial institution.

As with CDOs, Chinese investors and banks alike may have grossly underestimated the hidden risks associated with WMPs.

The last major issue related to WMPs is their connection to riskier assets and rates, including stocks, bonds, exchange rates, and -- perhaps most worryingly -- trust products. According to Nomura Global Economics, more than a third of WMPs are linked to trusts. Given that trust products have been characterized by Nomura and others as "the weakest link in the financial leverage chain," it will be interesting to see how WMPs fare if default rates in the trust sector accelerate.

Signs of stress
Already, problems associated with WMPs' lack of transparency and poorly defined credit terms have emerged in various parts of China, only to be swiftly subdued by China's authorities, ostensibly to avoid investors from panicking. GMO's Edward Chancellor, in a recent white paper, summed up key developments:

"Salesmen employed by banks have reportedly earned commissions by selling third-party products without their employers' knowledge. Customers appear to have bought these third-party WMPs believing they came with a bank guarantee. In early December, the Shanghai branch of Huaxia Bank was beset by protesters after a WMP sold at the branch defaulted.

This incident was the first in a number of scandals concerning shadow banking credit. In the same month, customers at a branch of China Construction Bank in the northeastern province of Jilin claim to have been sold a WMP with guaranteed returns but suffered a loss of 30% of their principal. Citic Trust Co, a unit of China's biggest state-owned investment company, recently missed a bi-annual payment to investors on one of its trust products after a steel company missed interest payments on the underlying loan."

China takes action
It looks like China's authorities have taken notice and are determined to do something about the mounting risks associated with WMPs. In a statement released on Wednesday, March 27, China's banking regulator -- the China Banking Regulatory Commission (CBRC) -- announced new restrictions on WMPs in an effort to increase transparency and stem the risks associated with these financial products.

The new regulations are intended to limit the types of assets that proceeds from WMPs can be invested in. They also mandate banks to be more transparent with investors about the risks to which they are exposed. While analysts were expecting stricter regulations on WMPs to be enforced this year, some were surprised by the swiftness of the CBRC's actions.

At first glance, the new regulations appear to be a welcome development, suggesting that China's authorities are more serious than ever about confronting risks to the country's financial system. But unfortunately, they can't reverse the years of shady lending China's banks have already engaged in. Are the new restrictions simply too little, too late? That remains to be seen.

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