Despite deadline extension for new rules, valuation on net asset basis takes hold

China's banking industry is pressing ahead with transforming and upgrading of the wealth management sector to comply with new asset management rules.

The new rules aim to rein in risky lending practices in the financial system and eliminate banks' explicit and implicit guarantees to investors on wealth management products. So, banks have strengthened efforts to issue new WMPs valued on a net asset basis since last year.

WMPs valued on a net asset basis refer to non-principal-protected WMPs with floating interest rates－similar to open-end funds that are bought and sold on demand at their net asset value.

The key mechanisms to eliminate implicit guarantees include converting existing WMPs valued on an amortized-cost basis to a net asset basis and permitting new WMP issuances to be valued on a net asset basis.

This switch would make volatility in investment returns transparent to investors, incentivizing them to rely on risk assessment when deciding whether or not to purchase a WMP rather than soon-to-be-prohibited implicit guarantees, said Moody's Investors Service.

At the end of 2019, the balance of Chinese banks' WMPs valued on a net asset basis rose by around 69 percent from 2018 to 10.13 trillion yuan ($1.54 trillion), accounting for 43 percent of non-principal-protected WMPs outstanding, said a recent report from the China Banking Association.

While the volume and types of WMPs valued on a net asset basis increased significantly, the balance of WMPs with assurance of expected returns on investment fell 17 percent year-on-year to 13.27 trillion yuan at the end of 2019.

Fixed-income assets, especially bonds, are one of the main asset classes that non-principal-protected WMPs were invested in. Bonds made up almost 60 percent of the portfolio of assets to which non-principal-protected WMPs were allocated, the report said.

The People's Bank of China, the central bank, announced on July 31 that financial regulators have extended the grace period for the country's banks to comply with new asset management rules to the end of 2021.

The extension of the deadline for implementing new rules implies that implicit guarantees on WMPs will remain a key risk for Chinese banks, said analysts of Moody's in a research note.

"Nonetheless, we do not expect the delay to motivate banks to reverse the progress they have made so far in reducing noncompliant WMPs during the additional one-year transitional period. Regulators have made it clear that the one-year delay is a pragmatic arrangement to accommodate disruptions caused by the coronavirus pandemic rather than a course change in their reform of the asset management sector," said Nicholas Zhu, vice-president and senior credit officer at Moody's.

As banks are still under stress of rectifying existing WMPs, they will further accelerate the transformation of WMPs, improve the product system, strengthen investor education, and enhance their investment and research capabilities, the China Banking Association report said.

It is also estimated that more than 20 wealth management subsidiaries of banks will be officially open for business by the end of this year. Most of them will be established by large State-owned commercial lenders, national joint-equity commercial lenders, and leading city commercial lenders.

At the end of 2019, 16 banks had received regulatory approval to start preparing for the establishment of their own wealth management subsidiaries, and 11 of them had already set up such companies, the report said.

Data provided by Boston Consulting Group show that the size of China's asset management market, excluding principal-protected WMPs, hit 110 trillion yuan by the end of last year, up 3 percent from 2018.

For asset management companies, digital assets, including traditional assets that are circulated online in digital forms after technological innovations and new types of assets such as data, have brought them opportunities to build their data capacity, in order to have access to a wider scope of investable assets, conduct more accurate valuation analysis, and ensure more effective transactions and risk management, said a report jointly released by Boston Consulting Group and China Everbright Bank Co in August.

"For asset management companies including banks' wealth management subsidiaries, the core competence of the asset management industry is the power of leveraging data and human talent successfully, which is also a necessary condition for generating a continuous return on investment for investors," said Zhang Xuyang, chairman of Everbright Wealth Management Co, a wholly owned subsidiary of China Everbright Bank.