A Day of Reckoning for China's Trusts

Yifan Hu (PIIE)



The third and fourth quarter of 2014 will be a turning point in the trust industry, as repayments of interest and principal of trust products are expected to peak during these two quarters and remain high for 2015 as a whole. The combination of mounting payoffs and non-performing loans are likely to rattle the whole trust sector. The maximum amount of losses absorbable by trust companies, taking into account their level of capital, is equal to 255.5 billion renminbi. This would represent a default rate of 2.3 percent on their assets. Yet the average default rate of trust products between 2007 and 2009 was above 3 percent, implying several trust companies are likely to default in the coming months. Some investors will therefore have to assume losses on their investments in trust products due to insufficient capital and provisions among trust companies.

Because of increased default rates, higher leverage and stricter regulations, investors will have to accept bigger haircuts compared to previous episodes of distress in the trust fund industry. However, the biggest impact will be felt by trust companies themselves and the banks.

The trust sector will be exposed to a significant wave of reshuffling

The assets under management (AUM) of the trust sector broadly increased tenfold in 5 years to 10.9 trillion renminbi in 2013 compared to 1.2 trillion in 2008. This progression significantly outpaced all other major financial players including security houses, banks and insurance companies. The trust sector is now the second largest financial sector in China. Trust products have been the major contributor to the brisk growth of shadow banking in China.

The threat of a default on "2010 China Credit/Credit Equals Gold #1 Collective Trust Product" (“Zhichengjinkai No 1”) marked the beginning of 2014 by rattling financial markets and exposing the risks surrounding the Chinese shadow banking system. This event could foreshadow similar cases in 2014 as numerous trust products will mature this year, increasing the probability of defaults.


From second half of 2014 onward, the unconditional payoff rule is likely to be broken, while the system of compensation of losses will be less generous compared to the 2004-2006 period. Given the fact that losses are expected at a significantly higher level, there is a high probability that only investments below RMB 100K will benefit from a reimbursement, while “larger” investors may be exposed to losses without any compensation.

Trust firms, a large number of which adopted overly aggressive strategies, may increasingly face bankruptcy in the coming months. “Regulations on trust firms” require trust firms to bail out trusts products if they are considered as having been negligent in terms of due diligence. Recent reports suggest that reckless background checks and obvious over-valuation of assets are common practice in the trust sector. Trust firms with insufficient capital are likely to be acquired by large trust firms which have sufficient capital and parent companies with deep pockets. Consolidation in the trust sector is therefore expected to coincide with increasing default rates.

Intervention from the government via asset management companies or via the investor protection fund is likely to be adopted once the wave of defaults becomes too large. In 1999, China created four AMCs (asset management companies), namely Cinda, Huarong, Great Wall and Orient, to take over the bad debt of Chinese commercial banks. The same strategy could be adopted with the trust fund industry. AMC companies could acquire troubled assets from trust funds and gradually liquidate them. This “time for liquidity” strategy would benefit from the support of the government and the central bank.

Banks will have to absorb the bulk of losses in single trust products

The major investors in trust products are banks and wealthy individuals. Bankers are the ultimate lenders in most trust products, which totaled 7.6 trillion renminbi by the end of 2013. By using trust companies as a channel and other financial institutions as bridge actors, banks were able to circumvent the prudential regulations such as the capital adequacy ratio and the loan-to-deposit ratio.

Given that regulatory bodies are unlikely to bailout single unit trust products, and that single unit products represent 73 percent of the trust sector’s outstanding AUM, banks will be the most exposed to losses in the case of a quick deterioration in asset quality. Commercial banks are generally the beneficial owners of single unit trust products. They will therefore have to assume the losses linked these products. The bail-in capacity of the banking sector is unquestionable due to the huge size of capital and provisions. Assets of the commercial banking sector reached 125 trillion in first quarter of 2014. On the other hand, the current amount of single unit trust products due in 2014 amounts to 4.1 trillion renminbi. Assuming a non-performing ratio of 5 percent for single unit trusts in 2014, total loss of RMB 0.2 tn would trigger an increase by 0.2 percent of the total NPL ratio at the end of the year (NPL ratio of Chinese commercial banks was at 1.04 percent in 1Q14.). The shock is therefore largely absorbable by commercial banks.

The risk of an interbank market freeze

Via a complex chain using several bridge companies, banks can supply loans to risky companies via the issuance of trust products with the help of trust companies. The purchase of beneficiary rights backed on these trust products on the interbank market eventually allows banks to benefit from high returns linked to the original risky loans. In 2013, inter-bank activities linked to trust beneficiary rights under inter-bank activities were estimated to be 1.35 to 2 trillion renminbi, which accounting for 17.8 to 26.3 percent of single unit trust AUM in 2013. This process has contributed to the quick rise of interbank assets, which reached 21.5 trillion renminbi at the end of 2013 compared to 6.5 trillion at the end of 2008.

Increasing defaults on single unit trust products, of which beneficiary rights have played a growing role as collateral of liquidity transactions, could potentially spiral into a general freeze in the interbank market. The sources of risk are diverse and include maturity mismatch, collateral depreciation, shock of liquidity credit events and even bank runs.


New regulation and alternative sources of funding are needed

Better supervision of trust companies is urgently needed to address the growing risks in the trust sector. Supervision should be more holistic to take into account the variety of connections trust companies have to the rest of the financial system. Supervision of trust funds, internet financing, leasing companies, credit-guarantee outfits and money market funds should be integrated. Separately, diversifying financing channels by promoting development of the bond market, improving the listing process for initial public offerings and allowing full access to infrastructure projects by private capital are necessary to deal with the ongoing financing difficulties of small and medium-size companies.

Financial leases are one solution that could be explored to improve financing efficiency. Compared to other funding sources, financing leases do not require large down payments and can help companies keep their equipment up to date. Because of these advantages, financing leases may see a rapid boom in the coming years in sectors such as automobile, aeronautical and healthcare. The market size has been estimated at 3 trillion renminbi in 2014 and double growth is predicted for the next several years.

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