Credit FAQ:

A Key Test Case Looms For China's Shadow Banking System

Primary Analyst: Qiang Liao, PhD, Primary Analyst, Beijing (86) 10-6569-2915; qiang.liao@standardandpoors.com Secondary Contacts: Joseph M Leung, Hong Kong 852-2533-3553; joseph.leung@standardandpoors.com Ryan Tsang, CFA, Hong Kong (852) 2533-3532; ryan.tsang@standardandpoors.com

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Frequently Asked Questions Related Criteria And Research

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Credit FAQ:

A Key Test Case Looms For China's Shadow Banking System

The Chinese banking sector is approaching a testing moment. The market is focusing much attention on a high-profile Chinese renminbi (RMB) 3 billion collective trust program (CTP) that's now in distress, and for which Industrial and Commercial Bank of China Ltd. (ICBC) served as the distributor. All market participants--from investors to trust companies to Chinese banks--are now anxious to know if the CTP will get bailed out as such distressed trust products usually are, or will it be left to "default," which would be a first for its kind since 2005. Standard & Poor's Ratings Services does not currently believe ICBC will undertake an outright bailout. But no matter what ICBC's reaction is to the distressed CTP, its response may shed light on real exposures of Chinese banks to shadow banking and how vulnerable the banking sector really is (for an in-depth look at the China's shadow banking system, see "Why Shadow Banking Is Yet To Destabilize China's Financial System," published March 27, 2013). The events leading up to this situation began in early 2011, when China Credit Trust Co. Ltd. (CCTC), a state-owned trust company, launched a series of CTPs to make equity investments in Zhengfu Energy, a private coal miner. The RMB3 billion equity funding to Zhengfu was effectively a three-year debt finance because the private owner of Zhengfu is obliged to buy back the equities under the CTPs at a premium equivalent to an annualized funding cost of 17%. ICBC reportedly referred the transaction to CCTC and helped distribute the CTPs to ICBC's private banking clients with a prospective annual return of 11%. We understand the spread were treated as commissions and, according to local media reports, mostly went to ICBC. If true, such a commission split between the bank and the trust company is unusual because trust companies typically play an active role in managing CTPs and hence receive a significant share of commissions. The CTP funding to Zhengfu was first reported at risk in June 2012 when the private owner was arrested and charged with illegally raising funds from the public. Zhengfu was soon at brink of insolvency, putting the CTPs in danger of failure when the first one matures on Jan. 31, 2014. Following are some key questions about the looming failure of this closely watched CTP.

Frequently Asked Questions

What makes the CCTC/ICBC case special?
CTP is a kind of investment products in China that trust companies originate, manage, and distribute to high-net-worth investors. Trust companies may leverage on Chinese banks or nonbank companies' network to distribute CTPs. While CTPs may invest in any underlying assets, most CTPs invest in trust loans or other fixed-income obligations to fund credit-rationed risky segments and behave like a bond. Legally, trust companies are not held accountable for making CTP investors whole if their managed CTPs make a loss. But in reality, no single failure of bond-like CTPs has occurred since 2005. Instead, distressed CTPs were bailed out either by trust companies worried about reputation risks or being accused of negligence in due diligence and trust management, or by local government worried about

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Credit FAQ: A Key Test Case Looms For China's Shadow Banking System

economic fallout from liquidating the borrowers. But in this case, CCTC appears reluctant to bail out the investors given the significant size of potential losses and the paltry fees it earned. Local government also lacks incentive to bail out the CTP because a coal miner bankruptcy may not hit the local economy as hard as a failed manufacturer might. This would leave investors on the hook to bear the losses. ICBC has reiterated its claim of no wrong-doing on its end and having no intention of bailing out the investors from the largely evaporated trust investment. But the market is speculating that ICBC may assume major losses for the sake of containing collateral damage from Zhengfu's bankruptcy, mitigating its own reputation risks among clients, and remedying unusually high commissions it charged on the deal.

Do you expect ICBC to bail out the CTP?

No. We believe an outright bailout by ICBC appears beyond the bank's options. First, ICBC has no legal ground to make such a bold move. Indeed, a bailout might trigger shareholder litigation against the bank. Second, damage to its reputation from the failure of such a high-yield and high-risk product may be well manageable. This is because the high-yield wealth management product (WMP) market is distinct from the mass WMP market in terms of the clientele base and risk-based pricing. We do not think a "default" of high-yield WMPs by itself will create panic among WMP investors because there have already been quite a few failure cases of WMPs in general, rather than CTPs specifically, in the market. However the failures were mostly linked to the equity market, forex, or commodities. Third, and perhaps key, policymakers may also be less concerned by such a failure than they used to be. Given the limited number of individual investors affected and these investors' high-net-worth status, the risk of triggering social unrest appears limited. Indeed, Standard & Poor's expects Chinese banks to take differentiated positions toward distressed WMPs they have distributed. We hold the view that Chinese banks are unlikely to bail out high-yield WMPs unless the banks happen to be the originator of the products. In China, trust companies or unregulated nonbank entities originate most high-yield WMPs. On the other hand, we view mass-market WMPs, which dominate outstanding WMPs of Chinese banks, as term deposits in disguise, and we expect timely and sufficient liquidity support from the originating banks.

So, do you expect this CTP to "default," and investors to bear the losses?
We are inclined to believe that the CTP will fail. Chinese policymakers have long recognized the moral hazard stemming from "make-whole" practices and the detrimental impact to economic balance. But significant uncertainty remains. Things have been moving fast toward the maturity date. CCTC announced on Jan. 22 that the local government just renewed some permits Zhengfu held for coal mining, which could boost asset values under the CTP and make CCTC's efforts to sell trust assets to third parties a little more likely. Local media reported that PICC Group, the state-owned insurer and CCTC's single-largest shareholder, was in talk for a potential purchase. The ambiguous and inconsistent policy stance of the China Banking Regulatory Commission (CBRC) may play a role in the stakeholders' decisions, too. While the regulator has long asserted that investors should bear the risks of a trust investment, the CBRC has recently appeared to favor trust companies' "make-whole" practice, fearing that a CTP failure may severely undermine investor confidence in the entire trust company industry and lead to unpredictable consequences on China's shadow banking universe and the economy. Bear in mind that CTPs are usually launched to

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Credit FAQ: A Key Test Case Looms For China's Shadow Banking System

fund credit-rationed risky segments like property developers, local government financing platforms, and companies in industries facing overcapacity. While the policymakers have discouraged credit supply to these segments, they may not want to see a sudden credit crunch triggered by a CTP failure. However, we believe relevant stakeholders will have to assume significant losses. Regardless, we expect CCTC to be the major loss bearer because of its vulnerability to reputation risks and litigation risks for alleged negligence. We do not expect ICBC will explicitly assume any losses unless a court orders it to do so. But this does not rule out ICBC compensating the trust company's losses by offering it other business, given the bank's referral role in the product's origination and unusually high commission rate it charged for the distribution services. If the CTP fails, we also expect investors to bear some losses given the high risks the high yield implied and the investors' presumed financial sophistication.

What if ICBC chooses to bail out the CTP?

ICBC's case provides a rare chance for us to learn how Chinese banks would react to failing high-yield WMPs that they distributed. If, contrary to our current thinking, ICBC does bail out the CTP, we will have to review our assumptions about Chinese banks' credit exposures to shadow banking. A bailout by ICBC may trigger an event-driven review of our Banking Industry Country Risk Assessment (BICRA) on China and our stand-alone credit profile (SACP) assessment of ICBC. This is because the banking sector's actual credit exposures to shadow banking could be greater than what we currently think. Even if we conclude the impact on China's BICRA would be limited, it may still undermine our current "adequate" assessment of ICBC's risk position and weigh on ICBC's SACP. Nonetheless, we do not expect downward pressure on the rating on ICBC because of our assessment of a "very high" likelihood of extraordinary government support, which may offset such downward pressure on the SACP.

What if CCTC or other stakeholders, rather than ICBC, bail out the CTP?
It seems to be "business as usual". But this will only reinforce the entrenched investor perception that "everything" in the debt market will enjoy government support. Such a perception has led to a lack of due diligence/credit assessment for borrowers, and too much build-up of risk in the system. This is an underlying reason why China's shadow banking has been flourishing in recent years despite all the regulatory initiatives to contain the growth of shadow banking. If the CTP is bailed out by others, the moral hazard and potential problems in the system will continue to grow. While our BICRA on China is unlikely to face immediate downward pressure, a good opportunity of instilling market discipline will have been missed.

What's your view on the credit implication of shadow banking on China's bank sector?
We believe shadow banking could have significant and far-reaching implications for the banking sector's financial soundness in the next few years. Shadow banking highlights leverage in the economy and the efficiency of capital allocation, which are among the key long-term determinants of the banking sector's credit performance. We believe orderly growth in China's shadow banking market, particularly in the form of a deepening and functioning debt capital market, could benefit the banking sector if it leads to efficient capital allocation and thereby diminishes the government's dominant role in financing.

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Credit FAQ: A Key Test Case Looms For China's Shadow Banking System

However, China's shadow banking system currently poses more risks than potential benefits, in our opinion. This is because the already-high debt levels of corporate China leave little room for a further productive rise in leverage, particularly given that a significant proportion of shadow banking credits flows to uneconomic investment projects. Nonetheless, we continue to view China's shadow banking more as a symptom than a cause of some emerging systemic risks to the banking sector and the wider economy. In our view, Chinese banks have already accumulated high credit risks on their balance sheets. But distorted growth in shadow banking could lead to further unintended buildup of credit risks that banks may not fully appreciate. Certain parts of the shadow banking sector, notably trust companies, may prove to be the weak link of China's financial system.

Related Criteria And Research

Related Criteria
Banks: Rating Methodology And Assumptions, Nov. 9, 2011 Banking Industry Country Risk Assessment Methodology And Assumptions, Nov. 9, 2011

Related Research
Banking Industry Country Risk Assessment: China, Jan. 9, 2014 2014 Asia-Pacific Financial Institutions Outlook: Rising Private-Sector Leverage May Overshadow Banks' Performance Amid Softer Economic Prospects, Dec. 10, 2013 Why Shadow Banking Is Yet To Destabilize China's Financial System, March 27, 2013

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