Black box

Chinese trust companies, or xintuo gongsi, are very different animals from their Western brethren, combining elements of asset management, banking and private equity. The short history of trust companies in China has not lacked unhappy moments. Since the industry came into being roughly 30 years ago, it has more often than not been linked with rampant fixed-asset investment, economic overheating and stock market speculation. This led many trust companies into bankruptcy in past decades, stalling industry growth and requiring regulators to step in.

But today the industry has changed, due to the incessant efforts of China’s financial regulator, the China Banking Regulatory Commission. The CBRC issued a trust law in 2001 and management regulations in 2007 that transformed trust companies from proprietary investors for banks and government bodies into platforms that make and issue investment products. As their new business model started to take shape, their total assets under management (AUM) began to soar. AUM for the industry grew at a compound annual rate of 72.4% between 2006 and 2010 and reached RMB 4.1 trillion by the end of September this year.

Fingers in every pie

In the past, trust companies’ principle source of strength has been their flexibility. Unlike banks, brokers and fund managers, trust companies participate in almost every sector of China’s financial industry and their products cover almost every asset class available in China, from infrastructure projects and asset securities (mainly the so-called “bank-trust products,” or re-packaged bank loans) to public and private equities and alternative assets like art or wine.

This flexibility allowed trust companies to spot opportunities and quickly develop products to target that demand. In 2008 and 2009, for instance, China’s central bank urged banks to stimulate the economy by lending. Not even the PBoC’s expanded quota could satisfy their appetite for granting loans, and banks turned to trust companies for products that removed loans from their balance sheets. The government then tried to rein in liquidity and housing prices by restricting property sales and lending, creating a great thirst among property developers for financing in the form of real estate trusts.

But the industry’s flexibility has also been a weakness. Though trust companies provide a variety of financial services, they cannot compete with banks in financing, for example, or fund managers in investment management. The result is that trust companies, regardless of their fast growth in the past few years, have fled from one product to another. Sometimes theses niches have already been passed over by other financial institutions – for example, real estate trusts arose because banks refused to lend to property developers – meaning that the trust companies which meet these demands are likely taking on greater risk.

Trust companies are also weak in branding, management and distribution. Over time they have become more like supplements to other financial institutions. This is evident in their product portfolios. By the end of the third quarter, 40% of the industry’s AUM came from bank-trust products, which are in essence a product packaging service for banks. Due to their lack of management capacity, only about 3% of AUM came from private funds, the most dynamic part of their investment management business, and only 0.01% came from private equity and Qualified Domestic Institutional Investor trusts. The remainder, more than half of the total AUM, came from various loan or debt investment trusts.

What’s at stake

Many people wonder whether the trust industry is exposed to considerable risk through its current product portfolio. The answer is that the risk of default for a given product might be smaller than investors think, but there are other risks they may not be aware of.

The heavily criticized bank trusts, for example, are actually relatively safe, because banks usually deploy their good loan assets for these products, unlike collateral debt obligations in the West. In addition, trust companies’ involvement in these products is only limited to packaging, making these more like bank products than trust products. Most of the loan products that trust companies offer are also quite safe, because they are usually collateralized by the borrowers’ equities or assets. The default risk is only high in certain sectors, such as real estate trusts, which account for only about 0.8% of the industry’s total AUM.

What the CBRC is really worried about, other than the risk of default, is that trust companies will be unable to build a competitive business outside of product re-packaging. China’s trust industry was only recently reborn from deadly mistakes. The risk is that if trust companies do not build their competitiveness with other financial institutions, they may fall back into the dangerous management style that dominated several years ago.

Over the past few years, trust companies have grown weak in tandem with the economy. When the economy recovers, total AUM in the financial industry is likely to rise quickly. The CBRC’s goal is for China’s trust industry to be well-positioned in terms of expertise and benefit to the economic system when this liquidity returns. To that end, the CBRC has imposed a system similar to banks’ capital adequacy ratio, stipulating that trusts must hold net capital of at least US$29.6 million or 40% of net assets, whichever was greater. It also asked companies to reduce their exposure to bank and real estate trusts.

Buying in

These reforms are likely to transform the industry, though it’s not yet clear what the long-term model will be. One solution that the CBRC is backing is for trust companies to focus on investment management, likely private funds, private equity and alternative-asset trusts for high net worth individuals.

Large trust companies like Ping An Trust or CITIC Trust are expensive to buy into and may not even consider selling stakes to foreign investors. But for smaller entities, the time to invest is ripe: Many trust companies are facing cash shortages due to CBRC’s new capital requirements. However, potential investors should keep in mind that the outlook for the industry is uncertain and may remain weak for the next three to five years.

Ivan Shi is a senior associate at Z-Ben Advisors