China Intensifies Efforts To Curb Risk In Troubled Trust Sector

Economic

Summary:

As well as increasing the focus on risk control and services such as wealth management, new regulations aim to discourage trusts from acting as conduits for shady investments.

Profitability is out and risk management is in. That’s the message in the latest set of regulations for China’s trust companies aimed at controlling a 22.6 trillion yuan ($3.1 trillion) industry that continues to be beset by scandals after a years-long overhaul.

The rules, which replace regulations introduced in 2016, went into effect in November and put greater emphasis on risk prevention, encouraging trust firms to focus on providing wealth management services rather than acting as financing channels, experts and industry sources said. They also aim to limit the development of problematic trust firms by implementing differentiated supervision.

An updated regulatory ratings system has been introduced, switching the focus to risk management and supervision of how businesses are run rather than profitability and revenue, metrics that are no longer included in the ratings system. The rules also, for the first time, allow financial regulators to evaluate the systemic importance of large trust firms and impose stronger oversight on the most important ones. “The direction of the regulatory ratings system has obviously shifted from fostering development to preventing risks,” a trust firm executive told Caixin.

The measures are the latest attempt by policymakers to rein in risks and bring about more effective oversight of the trust sector after a string of scandals over the past few years exposed corruption, poor business management and lax regulation.

In June 2020, investors of Sichuan Trust Co. Ltd.’s products protested outside the headquarters of the trust firm after it defaulted on products that had matured. The firm was taken over by local financial regulators later that year.

Last year, Zhongrong International Trust Co. Ltd. failed to repay investors in some of its trust products. Its second-largest shareholder, Zhongzhi Enterprise Group Co. Ltd., subsequently filed for bankruptcy liquidation after disclosing a financial shortfall of as much as 260 billion yuan.

China had 67 licensed trust companies as of June 2023, government data show. Many were key players in the shadow banking industry, providing loans to high-risk companies, including real estate developers, and those who struggled to obtain credit from banks.

Differentiated supervision

The new ratings system tailors regulatory measures to a trust company’s profile based on five main categories — corporate governance, capital, risk management, operation management and business transformation. Each company is awarded a score of up to 100 points based on their performance and is given a ranking ranging from 1, the highest, to 6, the lowest, based on their overall score. Levels 5 and 6 indicate high-risk entities. Those with lower rankings will be subject to more stringent supervision, including more frequent onsite inspections.

The National Financial Regulatory Administration (NFRA), which set the rules, has also introduced a systemic importance assessment to identify the biggest trust firms whose failure could create significant liquidity or credit problems and disrupt the normal functioning of the finance sector. They will be selected from 30 firms with the largest amount of trust assets based on a number of weighted criteria, including the value of assets under management and the number of individual investors. A firm that scores 85 or higher in the assessment will be deemed systemically important and face stricter regulation.

The update of the regulatory ratings system highlights investor protection, and guides trust firms to maximize the legitimate interests of their clients, the NFRA said in a Q&A about the rules. Applying differentiated supervision based on systemic importance will help maintain financial stability by reducing the likelihood of a systemically important trust firm failing, it said.

If a trust firm’s rating doesn’t reach level 1 or 2, its business operations may be limited, according to a source who works for a midsize trust firm. “From the perspective of competition within the industry, the Matthew Effect will be more pronounced,” he said, referring to a phenomenon where the strong become stronger while the weak get weaker.

Risk prevention

One of the key changes in the new regulatory ratings system is the downgrading of profitability as a criterion. A trust firm’s regulatory rating based on the 2016 framework would be affected by its profits, revenue and return on equity, but these metrics no longer play a role. There is now far greater emphasis on risk management, corporate governance and operation management, which in total make up 70% of the weightings in the updated system.

In addition, risky activity will lead to a ratings downgrade. A trust company found to have repeatedly carried out related-party transactions that violate regulations and lead to the misappropriation of company assets or cause severe harm to investor interests will have its rating lowered. Other misconduct that will lead to a cut includes providing payment guarantees for trust products, repeatedly selling products to unqualified investors, and acting as channels for regulatory arbitrage for other financial institutions.

Trust firms in China enjoy more freedom than many other financial institutions in the types of assets they can invest in, and are often used as conduits by other financial institutions to skirt regulations and invest in risky assets — a practice that has raised concerns among regulators.

“This time, regulators are trying to weed out the riskier companies,” a general manager for strategic research at a trust company said. “Trust firms with different levels of risk will face different regulatory attention, and the focus will be on specific areas of risk and corrective measures to address them.”

Focus on core business

“Business transformation” is a new metric in the updated rules. It aims to encourage trust firms to develop core businesses such as charitable trusts, as well as asset management and asset service trusts, and downsize “businesses that need to be rectified,” the NFRA said in the Q&A. Asset service trusts involve providing tailor-made services such as wealth planning and inheritance, custody and risk management.

Systemically important trust firms with a regulatory rating of 3 or higher can be given priority to pilot “innovative businesses,” the rules said. This could include managing company pension funds and investing funds in offshore assets, a trust company executive told Caixin.

The new rules are, overall, conducive to the long-term development of the industry, Zeng Gang, director of the Shanghai Institution for Finance and Development, told Caixin. They aim to guide trust firms to transform their businesses away from acting as financing channels and toward their original purpose of being a fiduciary entity to manage client assets, he said.

He noted that trust funds have been invested mainly in real estate projects and as loans to local government financing vehicles, companies set up by local authorities to raise funds for infrastructure investment. This is a deviation from what trust firms were originally intended for — managing wealth on behalf of their clients, he said.　

As regulators apply different levels of supervision to trust firms based on their ratings and systemic importance, they will provide more support to the good players, and put a check on the development of the bad apples, Zeng said.

Source：CaiXin

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