Securities and banking regulators in China have made it clear to commercial banks that they must have a foreign equity partner in any fund management unit they establish, according to a variety of sources in Hong Kong and Shanghai.

This opens up a new opportunity for foreign fund houses looking to enter the market, but some analysts warn such deals may be a trap.

Industrial & Commercial Bank of China (ICBC) is widely expected to be the first commercial bank to win approval from a host of regulators to set up a funds management business.

Other banks said to be keen are China Construction Bank, China Merchants Bank and Bank of Communications. BoComm is rumoured to be pressing HSBC, which owns a 20% stake, to partner in a funds JV - regardless of HSBC Asset Management's announced deal with Shanxi Provincial Trust.

China Merchants is said to be so keen it is considering restructuring the successful JV between China Merchants Securities and ING Investment Management. Officials at that JV could not be reached by press time.

Although banks such as ICBC have a stranglehold on funds distribution, they have stood idly by as most revenues have gone to the fund managers. Banks are beginning to negotiate for trails on management fees, but mainly rely on custody and sales charges, and even the biggest distribution machines at organizations such as ICBC and China Construction Bank are not very profitable.

Realization that these banks will need foreign partners has only recently crept into the market and has a lot of players without a mutual funds joint venture excited, because partnering with a bank should mean ready access to huge distribution platforms.

"Introducing foreign expertise to these new fund companies will be very good for the industry," says a foreign funds executive in Hong Kong. "We've been looking at a means of market entry for some time and this could be important."

Says an industry dealmaker, "A lot of my foreign clients say no bank, no deal." A few foreign firms are putting ongoing negotiations with Chinese securities houses for a fund management JV on hold, in order to see if the new prospect of a bank deal comes through.

"This is greenfield for a lot of people, it's come out of the blue," says an industry analyst, who adds that regulators had talked about needing foreign technical advice but not necessarily an equity stake. "It's made things more complex. A lot of banks have sister companies with foreign fund JVs."

Moreover because the regulators, including the China Securities Regulatory Commission and the China Bank Regulatory Commission, have not finalized their rules, the banks still do not know what they can and cannot do.

A Shanghai-based executive at a foreign fund house says this should not be a surprising move, however, as the writing was on the wall since mid-2004 when authorities first indicated commercial banks would be let into the funds business. "The banks are undergoing huge reorganizations and they need strategic investors. It follows that different businesses will require different foreign partners."

The domestic funds industry is full of small fry with little hope of advancing without a good partner. Some of these players had waxed hopeful that a bank, looking for a partner to enter the funds business, would acquire them. But, says the foreign funds executive, "This is wishful thinking. There'd be nothing in it for the bank."

Although partnering with a bank clearly appeals to some foreign players looking for an entry, local experts warn that banks may not make good bedfellows.

First of all, the froth has come out of the China funds story. While the industry has had a good year and asset levels are steadily rising, the number of competitors has squeezed out profits.

"Two years ago everyone wanted in, but now the industry is struggling," says a fund manager in Shanghai.

This means that foreign financial institutions may be looking to establish relationships with Chinese banks, but that the fund management component is tiny. "A foreign institutions should only do fund management with a Chinese bank if it wants to do other things as well," he says.

Second, while banks may be powerful distributors, they may not be very good at actually running a funds company. They are deposit-taking bureaucracies and their expertise will be limited to money market funds. Granted, in scale, this can be a good business, but may not give foreigners any way to add value.

Third, outsiders betting everything on a bank because of its distribution power are ignoring the global trend of open architecture. While open architecture does not exist in China, there are early signs of it. For example, Boshi Fund Management has successfully marketed its funds among multiple bank channels - and eventually it will come.

Fourth, Chinese business culture tends to encourage big domestic institutions to bend over backwards for foreigners looking to make a deal, but treat partners badly, says a consultant with funds M&A experience. "As a partner it would be much harder to incentivize bank staff to sell your funds," he thinks. "These are bureaucratic monsters with smart guys at the top but the sales people will push a fund only if you give them cash. And you can't do that if you're part of the JV."

Fifth, a foreign fund house is never going to gain management control of a bank's mutual funds business. Securities companies, on the other hand, may be small but are often staffed by savvy people who know how to sell financial products, and in some cases, foreigners have achieved de facto control.

But despite these challenges, some foreign players are going to see this as the opportunity they have been waiting for. For the time being, bank distribution does remain the name of the game; and the Chinese banks are keen to find partners.