Tailor-Made Funds for Bank Investments Fall Foul of Regulators
(Beijing) — Always on the look-out to increase their returns in a low interest-rate environment, China’s banks have poked their fingers into a multitude of financial pies. Last year, as money flowed in to deposits and wealth management products, they piled in to products offered by fund management companies that cater specifically to the needs of commercial banks.
Known as tailor-made funds, these products had two main attractions for banks seeking to outsource their investment management. First, the profits were exempt from the 25% corporate income tax that banks normally have to pay on gains from other types of investment. Second, they were able to influence asset allocation, some going so far as to directly tell the fund manager what to buy, although technically this was a breach of regulations.
Each fund needed a minimum of 200 investors — individuals or institutions — and a total investment of at least 200 million yuan ($29 million). It also needed approval from the China Securities Regulatory Commission (CSRC).
Other than those requirements, the funds were free to find their own investors and to set their own investment strategies and targets. What set these funds apart was that most of the investment — more than 90% according to industry observers — came from just one bank.
Launching a tailor-made fund is easy, a sales manager with a fund management company in Beijing told Caixin. “As long as we get the bank’s investment, finding the other 199 investors is not a problem at all. We have several hundred employees in our company alone. Each of them chipping in 100 yuan would be enough.”
Tailor-made products were all open-ended funds, which meant investors could withdraw their money at any time. That left the management company highly exposed if the anchor bank suddenly wanted its capital returned.
This liquidity vulnerability became evident late last year during the bond market rout when banks rushed to pull out of the funds at the same time. Fund management companies faced huge pressure on their cash resources and had to liquidate their bond holdings to meet redemption demands. This turned into a vicious cycle, as the drop in bond prices caused by selling triggered more redemption demands and more selling which in turn led to lower prices.
The turmoil in the bond market had many causes, but many analysts have argued that one major factor was banks that had made significant investments through non-bank financial institutions, including fund managers, withdrawing money en-masse. In the ensuing regulatory post-mortem of what happened, the CSRC moved in on tailor-made funds.
Although there has been no official announcement, people familiar with the matter have told Caixin that the watchdog has stopped approving funds that it suspects cater primarily to only one institutional investor. It has also started work on drafting rules to improve supervision of these funds and control their risks, they said.
In December, the CSRC required all fund management companies to report whether a new fund was tailor made for one big client. If it was, the company would need to provide additional information on the client and on how it planned to manage the fund.
There are no data available to show how many applications for new tailor-made funds have been made since the new requirement, but sources from several fund management companies told Caixin the commission has not approved any of their products that it suspects fall into this category. There are also no data to show how many funds launched last year were categorized as tailor-made products.
In fact, there is no regulatory definition of a tailor-made fund. But it can be identified by certain patterns, according to industry analysts, who describe its main characteristic as having a fat head and a skinny tail. The fat head refers to the chunk of capital provided by the main investor, the bank, which can run into several hundred million yuan, while the skinny tail refers to the 200 or so other investors who typically contribute only several thousand yuan each.
Caixin reviewed the public registration records of funds offered to the public that required CSRC approval in the first nine months of 2016 and found that 145 displayed this pattern, accounting for more than 14% of the total launched during that period. In October, records suggest that 26 tailor-made funds were registered and a further 79 in November, accounting for more than 40% of the total number of funds started in those two months.
According to research by Huachuang Securities, fewer than 30% of bank wealth management funds were invested in bonds at the end of 2015. Six months later, the ratio had risen to 40%, which translates into a flow of 3.69 trillion yuan from banks into the bond market during the first half of 2016. Research by several securities firms shows that they believe most of this investment was carried out not by the banks themselves, but on their behalf through other financial institutions such as fund management companies.
Bond Market Rout
This massive inflow of money into the bond market boosted a record bull run that started in late 2013, which saw the yield on the benchmark 10-year government bond fall by more than 180 basis points to around 2.6% in September. Concerned about the bubble in the bond market and the potential risks emanating from the leverage financial institutions had taken on to speculate in the market, the central bank in October started to tighten the supply of cheap, short-term funds in the interbank market that had fueled the boom.
This increased cost of borrowing short-term funds meant it was no longer profitable for speculators to use those funds to buy higher yielding bonds, and some started to lose money. On top of that, several bond scandals severely dented investor confidence, causing many to pull out of the market. The combination was toxic and as more and more investors, including the banks, sold bonds to avoid losses, prices slumped.
“When funds (from banks) started flowing in the other direction, the domino effect was inevitable,” the manager of the asset management department of a city commercial bank told Caixin.
Given the role played by tailor-made funds in the rout, the CSRC has turned its attention to regulating the products. Officials from the commission recently held a meeting with executives from several fund management companies, sources with knowledge of the meeting said.
Based on minutes of the meeting seen by Caixin, the discussions centered on whether the fund management company itself and/or its employees, should invest a minimum total of 10 million yuan into any fund that’s tailor-made for a bank.
“This rule is meant to force fund management companies to control the size of their tailor-made funds,” a sales manager at a mutual fund company in Beijing said. If implemented, the rule will restrict the number of funds a firm can set up due to the capital involved, he said.
The meeting also debated whether a tailor-made fund where more than half of the capital is provided by a single investor should operate as a closed-end fund or at least have some restrictions on redemptions, which would reduce the liquidity risks that come with open-end funds, a risk control officer with a fund management company told Caixin.
“With a closed-end fund, the fund management company can discuss a redemption with the bank in advance so that it has time to prepare the cash, possibly as much as one month ahead,” he said. “This would minimize the impact on the market.”
Banks have long been allowed to buy investment products from other financial institutions and to outsource the management of their investments to third-party professional asset managers including mutual fund managers, trust companies, securities firms and private funds. But this is the first time the securities watchdog is drafting regulations specifically for banks who undertake such entrusted investments.
A source close to the CSRC told Caixin that the aim is not to put a halt to the business, but to help investment companies better manage their risks and protect the interests of the small investors at the skinny-tail end of the fund. The regulations also aim to better align the fund management company’s interests with those of the banks by requiring it to invest more of its own capital into the fund, the source said.
Some fund managers and banks are already re-thinking their use of tailor-made funds in the wake of the bond market debacle, regardless of any new regulations that might put additional controls on their business.
“This sector has grown too quickly and it’s time we slowed down and took time to digest the growth we’ve experienced,” a bond investment manager at a fund company told Caixin. Banks are also reassessing the risks of outsourcing their investment to other financial institutions, he said.
As a result, even without new regulations, entrusted investment, and tailor-made funds in particular, may already have passed their prime.
Contact reporter Wang Yuqian (email@example.com)
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