China’s securities watchdog is said to have issued new rules on applications for new fund products design to package commercial banks’ exposure to bonds, amid concerns about rising liquidity risk. The aim is to protect retail investors’ interests and ensure the independence of fund managers.

The China Securities Regulatory Commission (CSRC) is seeking to monitor liquidity risks associated with a new wave of outsourcing by banks. It reportedly issued an internal notice last week asking fund houses to clarify whether new applications to fund firms were to run tailor-made products managing fixed income assets.

If so, fund firms must not have an arrangement with institutional clients that they will provide guaranteed returns. They must make independent and discretionary investment decisions without incorporating any requirements from the banking clients. The managers must also disclose potential risks in product prospectuses for retail investors.

Rising outsourcing by banks

The move comes after a new wave of outsourcing from banks to fund firms this year. Chinese commercial banks, particularly small city and rural banks, tend to lack investment capabilities and experience in financial assets. This is because they traditionally buy and hold government bonds or allocate to non-standard credit assets (NSCAs – typically packaged loans or debt for financing infrastructure or property projects).

However, local 10-year government bond yields have dropped below 3% in the past year, and the regulator plans to tighten the rules around smaller banks’ wealth management product (WMP) exposure to risky NSCAs. As a result, banks increasingly need to use external managers for investments into traditional financial assets such as high-yield credit.

Some banks are outsourcing as much as 70% to 80% of their WMP assets to fund managers for bond investments, said sources. As a result they could ask fund firms to invest in specific types of credits for them under one tailor-made product.

Most of this outsourcing this year has been into higher-yielding fixed income and driven the growth of Chinese bond funds. Such products' assets under management grew 88% in the first 10 months of 2016, as against fund industry growth of 4%, according to the Asset Management Association of China.

The trend is reinforced by the fact that fixed income funds recorded Rmb20 billion of net inflows in the third quarter, while equity and balanced funds recorded slight net outflows of Rmb1 billion and Rmb1.6 billion respectively, said Rachel Wang, Morningstar’s director for manager research in Shenzhen. A total of 85 new bond funds were launched during the third quarter, according to CSRC data.

Liquidity risk worries

“The main purpose [of the new rules] is to protect retail investors,” said a Shanghai-based consultant, who requested anonymity, as the rules have not yet been officially announced.

The CSRC is concerned about the potential liquidity risk of institutions redeeming mandates from such products, he noted. In such cases, retail investors would suffer as the fund's value would drop significantly.

“Whether the new requirement will curb the growth of tailor-made bond funds is not clear – we need more time to observe,” added the consultant.

Chinese banks’ outsourcing has also sparked concerns among market observers about asset managers' risk controls.

Morningstar’s Wang noted that commercial banks tended to have similar risk preferences when it came to investments. This will exacerbate market risks, especially for the bond market, if banks decide to make mass redemptions at similar times, she said.

Moreover, the regulator also wants to prevent fund firms from taking clients’ orders and helping them to access risky credits, added the unnamed consultant. Conducting such activity means they would be acting like a passive platform for commercial banks rather than offering active management services, he noted.  

AsianInvestor's forthcoming December issue will feature an in-depth discussion of this investment outsourcing trend among commercial banks.