Ten seconds into the interview, the man burst out laughing. The prompt was two seemingly innocuous questions from CHINA ECONOMIC REVIEW born out of very real confusion: Where do China’s trust companies fit into the country’s financial system? And, more to the point: What on earth are they?
"It took me at least five years to figure out what this animal is all about," the man – speaking on condition of anonymity, so hereafter referred to as Chen – said.
Given Chen’s extensive financial background, not to mention his involvement in an attempt to invest in a Chinese trust company several years ago, this was quite an admission, but it was delivered with no apparent embarassment.
It was also a sign of the complexities involved in any discussion of trust companies in China. While the business and fate of these small financial players are now widespread concerns, their business remains relatively opaque and their fate is obscured by uncertainty.
China’s trust companies hit the headlines in July with news that Beijing was cracking down on securitized loan products that had been offered by banks in cooperation with trust companies. A side-effect of the products was the neat removal of US$19.2 billion worth of loans off of banks’ books, according to estimates by ratings firm Fitch. This effectively allowed banks to issue more loans than permitted by Beijing’s annual lending target and the banks’ own capital requirements.
Senior leaders in Beijing, nervously watching the economy for signs of overheating amid massive lending sparked by the loose monetary policy of the last two years, were livid.
The China Banking Regulatory Commission (CBRC) responded by temporarily stopping all informal securitization deals between trust companies and banks. This was followed in August by new regulations: Banks must bring all off-balance-sheet assets that underlie wealth-management assets back on their books by the end of 2011, and are required to set up loss provisions as well as capital against losses.
Then, in September, another regulatory edict aimed at the trusts themselves: Trusts would have to hold net capital of at least US$29.6 million or 40% of net assets, whichever is greater, and were given 12 months to comply. Media reports called it an attempt to improve risk management and supervision of trusts.
It was a familiar phrase. Since the establishment of trust and investment companies in 1979, Beijing has been caught in a never-ending dance between regulation and allowing much-needed financial innovation.
Chinese trusts were born out of necessity: vehicles were required to provide long-term financing, often to construction projects. Largely free of the regulation encumbering the state banks, government bodies also found trusts useful for targeted financing of other strategic sectors. By 1988 the country counted 745 licensed trust companies.
Growth was helped by a freewheeling spirit and a booming construction sector. Jason Bedford, financial services manager at KPMG in Beijing, noted that even after the government began reining them in, trust companies exhibited a more liberal attitude toward risk than their stodgier financial siblings.
"Banks will do whatever’s explicitly permitted, whereas trust companies will do anything as long as it’s not forbidden," Bedford said.
When China’s real estate markets stumbled in the 1990s, trust companies involved in complex property investments ran into trouble. Guangdong International Trust and Investment Company (GITIC), thought to be too big to fail, became in early 1999 the first Chinese financial institution to be put into bankruptcy. Others followed. Between 1996 and the end of 1998, the number of trust companies in China plunged from 244 to 56. In 2000 – by which time Bedford says the sector’s debt stood at US$12-20 billion – the People’s Bank of China (PBoC), which then regulated the sector, forced all trust companies to reapply for certification.
The next several years saw the introduction of new laws and regulations to govern the sector. But it was not until the CBRC took over as regulator in 2003, launching aggressive investigations into malfeasance and pushing a regulatory overhaul, that trust companies began to cast off their tarnished image as the Wild West of Chinese finance.
"The professionalism of the trust companies varies, for sure, from extremely professional through to misunderstanding the financial industry," said Simon Gleave, Bedford’s colleague and a partner at KPMG. "[But] the CBRC over the last 10 years has really cleaned up the sector, got rid of the cowboy financing, so that image is wrong now."
In 2007, the CBRC said that it wanted trust companies to become professional institutions for managing third-party wealth, and to pursue reasonable financial innovation. The aim was "for trust companies to develop into risk-controlled, legally compliant, innovative and competitive professional financial institutions within three to five years."
Three years on, Beijing’s displeasure with the off-balance-sheet loan issue suggests the goal has yet to be reached. But what has emerged is a financial structure unique to China that is capable of providing long-term financing across a range of industries, using a license – provided by the CBRC – that in Western countries would be broken up between investment and commercial banks.
"Trust companies in China are very different in nature from their international counterparts," said Fran?ois Guilloux, director for regional sales at Z-Ben Advisors in Shanghai. "They don’t have any banking functions. Their primary function is to launch various kinds of products as the trustees of assets."
In addition, they engage in asset securitization, underwriting of securities and private investment consulting; some also act as private fund managers.
Under the radar
The relatively small size of trusts – total assets under management in 2009 were US$355.9 billion, compared with bank assets of US$11.5 trillion – and their low profile have also made them a useful alternative to banks, particularly for industries like property that face strict limits on bank borrowing.
"As the government places more restrictions on property companies to get financing, trust companies become a convenient vehicle for raising capital," said Chen. "[They’re] not as visible as a bank."
They have had other advantages as well. External investors, particularly foreigners, saw trusts as a route into China’s otherwise closed financial sector. Starting in the late 1990s, a number of high-profile foreign investors bought up maximum allowable 20% stakes in domestic trusts.
Most foreign investors in trusts contacted by CHINA ECONOMIC REVIEW, including Royal Bank of Scotland (RBS.NYSE), Macquarie (MQG.ASX), Morgan Stanley (MS.NYSE) and National Australia Bank (NAB.ASX) declined interviews or were not available to comment on their investments. In a statement, Barclays (BCS.NYSE), which in August 2008 received approval to buy a 19.5% stake in New China Trust (NCT) for US$35 million, said that it saw its investment as a chance to combine Barclays Capital’s strengths in financing, risk management and product development with NCT’s local trust market and renminbi debt market expertise.
It’s not just foreigners that have been enticed by the prospect of investing in relatively flexible and loosely regulated financial entities. State Development and Investment Corp (SDIC), China’s largest state-owned investment holding company, sees its interests in trusts as an important part of its overall involvement in financial services.
"Our goal in financial investment is to support the overall development of SDIC’s investment strategy, to make the most out of cooperation and make full use of pooling of profits," SDIC Vice President Lu Jun said in an emailed response to questions. "SDIC concentrates on managed trust products, especially those that have room to grow effectively in the future, and can resist the effects of inflation."
SDIC and other investors have a wide range of products to choose from. Part of the difficulty in establishing what China’s trust firms do is that they don’t all do the same thing. This has been true since the beginning, when many – but not all – trust firms were involved in financing for construction subsidiaries. As they have developed, some have carved out business niches; others have decided to stick with tried and tested formulas.
"Our main product is infrastructure project financing," said an employee at Hohhot Huachen Trust, who asked not to be named. "Equity products are very rare in our product family, as our management is very prudent about risk." While Hohhot Huachen’s products may not produce the returns of competitors’ products, he said, the firm offered investors comparatively lower rates of risk.
At Shanghai International Trust Company, another employee speaking on condition of anonymity described a different strategy. "Our focus is on equities and the real estate sector," he said.
Shenzhen International Trust and Investment Company, meanwhile, favors a mixed approach, incorporating securities, structured financing and large infrastructure projects. "We are good at risk control compared with competitors in a market where quite a few have gone bankrupt," an employee said pointedly.
Feeding the need
Trust company variety didn’t appear in a vacuum. In most cases, the products offered reflect client demand, and Shanghai is very different to Hohhot. With 61 licensed trust companies at last count, the result has been a proliferation of products even after the CBRC stepped in.
"Compared with several years ago, there are many changes, like more product choices and the emergence of riskier products for less risk-averse investors," said the Shanghai International Trust employee. "Investment returns have improved, but difficulties in risk control are increasing simply because of the increasing complexity of standards and the product mix."
The Hohhot trust employee concurs, and notes the pressure on trust companies to innovate and create high-return products. "Usually investors from first-tier cities are more risk-averse than those from other cities," he said. "But as long as there are high returns – even if the risk is high – it will attract capital from investors."
Several sources cited investor ignorance and underestimation of risk as a concern for financial sector firms of all stripes in China. It was also a significant factor in Beijing’s crackdown on bank-trust cooperation earlier this year.
High quality, high risk
The problem was not with the loans used to create the trust products, which Bedford at KPMG describes as "the crème de la crème, really safe products." Banks sold these loans to trust companies, where they were repackaged as trust products under an agreement that banks would later repurchase them. In a report released in July outlining the risks of this "informal securitization," Charlene Chu, senior director of financial institutions for ratings agency Fitch, outlined the crux of the issue:
"A key misconception about this activity is that as long as the quality of the investment products’ underlying assets remains strong, there is nothing to worry about. While asset quality is a key issue, Fitch’s greatest concerns currently center on liquidity risk, and the growing potential liabilities Chinese banks are taking on in this activity."
Investors with a poor understanding of how these products were structured tended to believe that banks had an implicit commitment to repay when the products matured. With no such obligations included in banks’ financial statements, however, this represented "a hidden call on liquidity," Chu wrote, and potentially a serious threat for smaller banks with less capital on hand.
"From a risk management point of view, it’s a bad idea," said Bedford. "I realize these are really top quality – safe, safe, safe, safe, safe – loans, but if they did go bad, and in theory all loans can go bad, banks can be liable."
That these products came under the microscope at a time when Beijing was intent on limiting bank lending led to widespread suggestions that banks had concocted them in collusion with trust firms to sidestep lending requirements. Bedford dismisses this as "rubbish," arguing that banks wouldn’t risk such a strategy for fear of a ferociously punitive response from the CBRC if it found out.
Given the risks to bank liquidity and potential regulatory wrath, it may be difficult to understand why banks would have offered these trust products in the first place. The answer, once again, is customer demand.
As of mid-September, China’s deposit rate stood at 2.25%. With inflation reaching a 22-month high of 3.5% in August, the effect has been negative real interest rates and the gradual erosion of depositors’ savings. Banks can’t compete with each other on interest, and therefore provide other, higher-return financial products to clients that request them. A bank’s inability or refusal to offer these services could mean a loss of business.
Not everyone buys this explanation. "It’s like saying, ‘But if I don’t sell crack on the streets of New York City, then someone else will’," said Chen, the industry insider, adding that he didn’t necessarily equate trust products with crack. But the reality is that banks are under pressure to boost business, particularly fee- and commission-based income, and securitized loan products fit the bill for now.
The regulator may have also been worried about the long-term effects of the practice on trust companies. The CBRC’s goal of "innovative and competitive professional financial institutions" was threatened by this close cooperation with banks, which provided trusts with an easy and steady but limited income stream from a particular kind of product.
As Ivan She, a senior analyst at Z-Ben Advisors, points out, the trust companies only provide the platform for these securitized loan packages, not the management or distribution. Their takeaway is small – the CBRC said the products accounted for two-thirds of total assets under management by trust companies, but just 10% of profits.
"The government is concerned that if the trust companies keep doing this, it will kill their remaining product development and management ability," She said.
The upshot of all this is a regulatory environment in which trusts are encouraged to pursue some kinds of innovation but not others – namely, cooperation with banks. True to their nature, different firms are noticing the effects to different degrees: The Shenzhen Trust employee said the firm’s bank cooperation business had seen a predictable and sharp decline. The trusts in Shanghai and Hohhot, which have more limited cooperation with banks, have felt only minor effects.
Still, says KPMG’s Gleave, most trust companies will be preoccupied over the coming months with ensuring that they meet regulatory requirements. "The key issue at the moment is the dismantling of the bank products. This is actually a lot of work. There were a lot of products. The legal process to run these products off will dominate the minds of these trust companies in the short term," he said.
There is some ambiguity about what will happen next. She at Z-Ben Advisors points out that the specific restrictions on bank-trust cooperation only carry through to the end of 2011. Beyond that, trust companies may be able to cooperate with banks, but under different circumstances than at present.
The more distant future is even harder to gauge, but a few clues paint a rough picture of a likely outcome.
It’s clear that the separation of banks and trusts – even if temporary – will force trust companies to develop and manage new financial products according to the investment needs of clients. It’s equally clear that Beijing intends the sector to remain vibrant but small. A KPMG report noted that CBRC rules introduced in 2007 were designed to ensure trusts focus on institutional investors and high-net-worth individuals (HNWIs). These more sophisticated players would presumably better gauge and survive the risks of relatively complex financial instruments.
Trusts’ narrowed client base and product portfolio makes one outcome particularly likely: a stronger move into wealth management. Some trusts – notably Hangzhou Trust, 20% owned by Morgan Stanley – have already begun this transition. As an advantage, HNWIs are less demanding than some traditional trust investors.
"High net-worth individuals in China, unless they’re from Wenzhou, don’t want these crazy returns," said KPMG’s Bedford. "They’ve been badly burned during the stock crashes." Increasingly, capital preservation and moderate growth will be the order of the day.
To that end, Wang Hao, a partner at Beijing-based law firm RayYin says that the CBRC appears to be interested in learning from the experiences of Western trust firms. "In May, CBRC non-banking department officials visited London and asked a lot of questions about how UK companies do [wealth management]. I feel that might be the direction."
Even the wealth management direction, however, has its complications. Chief among these is a lack of clarity over regulatory responsibility. While the CBRC is the sole regulator in charge of issuing trust licenses, as the companies expand into different products, they can come under the purview of other regulators.
The Shenzhen Trust employee complained that the confusion pushes up operating costs as companies don’t always know which agency to follow.
During the drafting of trust regulations in 2007, the CBRC was clear that it wanted to make trust companies into financial holding companies. "They wanted to give the trust companies roles in which they can do a lot of things, like securities companies: private placement, or being the underwriter in the IPO process," said Wang, who was involved in the process.
The only problem was that being an underwriter required approval from the China Securities Regulatory Commission (CSRC), which has to date issued no approvals. The issue remains in bureaucratic stasis; the banking, securities and insurance regulators all exist at the same level of authority, making it impossible for one to issue rules affecting another. Trusts hoping to expand their wealth management practices overseas might also encounter difficulties due to the need to coordinate with the State Administration of Foreign Exchange.
"At the beginning, [trust companies] were quite optimistic, that maybe they can do something revolutionary in the future," said Wang. "But they found out that they are still quite restricted to the old business practice areas."
It’s unlikely, however, that Beijing will be happy with too staid a trust industry. The CBRC knows China’s financial sector needs to develop through innovation, but the global financial crisis has understandably made it more reluctant than ever to allow innovation among banks at a scale that could destabilize the economy. Trusts, which are small and less likely to cause systemic risks, are a useful alternative.
"They don’t want financial innovation in the banking sector," said KPMG’s Bedford. "They want big, boring banks. Trust companies will continue to play quite a key role." And so the regulatory dance will continue.