Observers warn that low capital requirements and weak risk controls among the fast-rising subsidiaries of Chinese fund firms could lead to damaging investor losses.

Precisely a year ago the China Securities Regulatory Commission (CSRC) introduced landmark liberalisation to allow fund houses to establish a subsidiary with an expanded investment scope.

This was in response to the need for product differentiation and diversification among the nation’s 82 fund firms, which since 2009 had seen overall assets sink $164 billion, or 6.3%, to Rmb2.4 trillion ($392 billion) up until this June.

These entities, known as segregated-account (SA) subsidiaries, can invest in anything their parent can, but also in unlisted instruments such as private equity, limited partnerships, creditor’s rights (such as entrusted loans) and investment trust products, amongst others.

In many ways they were introduced to enable fund firms to compete on a more level playing field with trust companies, which span private equity, asset and wealth management and banking and can roll out services in response to market changes.

Fund firms have not been slow to take up this opportunity. To date 41, or exactly half, have set up SA subsidiaries. And as at June 30 these entities’ total AUM had grown to Rmb150 billion. 

Although still in their infancy, there is already the prospect that SA subsidiaries will not only challenge the position of trust companies – whose AUM stands at Rmb9.5 trillion – but overtake them.

Yet market participants are sounding the alarm, warning of underlying risks and a dangerous lack of regulation in this segment.

One consultancy analyst stresses that fund firms setting up SA subsidiaries for the first time are in danger of underestimating the risks involved handling in unlisted instruments, notably investments into real estate and local government debt. He points to a dangerous lack of regulatory requirements on risk control.

At present, implementing risk controls for these subsidiaries remains discretionary. Although the CSRC has said it will establish a department dedicated to supervising these entities, to date no details have been released.

While trust companies are governed by the China Banking Regulatory Commission and must adhere to strict rules and capital constraints – their net capital must not fall below 100% of total risk capital – fund management companies need only to file an application with the CSRC to set up a subsidiary and have Rmb200 million in capital. They also have no such capital constraints.

The analyst gives a scenario in which an SA subsidiary uses property as collateral – which they are allowed to do without guarantee. If that property project collapses, the subsidiary’s minimum capital requirement of Rmb200 million may be insufficient to cover losses.

Sandra Lu, a partner at Shanghai firm Llinks Law Offices, adds that while SA subsidiaries can offer unlisted instruments, there’s no stipulation that they are obliged to compensate investors in the event of a default. This risk lies with investors, and the fear is that is not being made clear.

Observers argue that a more thorough understanding of these underlying products and proper regulatory supervision are urgently needed before a scandal reduces the segment into crisis.

A feature on segregated account subsidiaries in China’s fund management industry appears in the September issue of AsianInvestor magazine.