Banking & Finance

The invisible loan

Why trust companies could be the next problem in the financial sector

The invisible loan

Now you see it...

Accounting gimmicks are back in the news this week, with new revelations about how Lehman Brothers managed to disguise its desperate financial situation in the lead up to its final downfall.

It did so by glossing up its balance sheet with “Repo 105” loans made temporarily to other financial institutions for cash under short-term repurchase agreements, which were then quickly bought back.

But financial window-dressing is reputedly flourishing further afield than Wall Street, with the Chinese banks also showing a taste for more complex financing techniques. One tactic that worries the local media involves a potentially unhealthy cooperation with trust companies.

In recent issues WiC has reported on the government’s efforts to rein in runaway bank lending. The authorities are worried about an overheating economy; meanwhile the banking regulator, the CBRC, fears a spike in bad loans.

The banks, however, may have found a way to keep growing­ the nation’s voracious appetite for loans – and in an ingeniously invisible way.

The process started last year. Banks sold their loans to trust companies that securitised the assets and then resold them to investors as ‘credit management products’ (which were then distributed through the bank that generated the loans). The banks found this a useful way to move loans off their balance sheet, so that they didn’t count towards their lending quota or impact their capital adequacy ratios.

The banking regulator disapproved: in mid-December it called a halt to this activity.

To get round this, the banks came up with a new financial trick that has become known as ‘trust-lending’. The bank in effect becomes an agency that helps its corporate clients borrow from the trust company. That means the actual lending relationship is between the borrower and the trust company.

The bank helps the trust firm finance this through the money markets, and then sells the resulting credit management product (as before) to investors. The only difference is that the loan doesn’t ever appear on its balance sheet – therefore bypassing the regulator’s disapproving eye. For this it earns a series of fees from the trust company, and the gratitude of borrowers – a high proportion of which are thought to be real estate developers (see Economy story, page 4).

One source in a Guangdong trust company told Southern Weekly that its ‘trust lending’ activities with the local branch of a state-owned bank are expected to be worth Rmb20 billion ($2.9 billion) in the first quarter.

All of this points to decreasing levels of transparency in the financial system. And as more debt gets hidden under the carpet, it will become harder for the government to direct the economy. Loans – even ‘invisible’ ones – have a multiplier effect throughout the economy, which is bad news for a government worried about inflation.

“The government relies on money supply and loan growth measurements to determine monetary policy,” Charlene Chu of Fitch Ratings told the Wall Street Journal in December. “But if you have banks extending a substantial amount of loans that officials can’t see and can’t control, management of monetary policy could become a problem.”

Trust companies don’t get much attention outside China. But they occupy a unique place in the country’s financial system as ‘non-bank financial companies’. There are 52 of them all told, and they helped solve the state banks’ bad asset problem in the 1990s. Back then the big four banks didn’t have enough capital so they injected problem loans into state asset management firms, and the trust companies hived off the better bits of their loans books.

It is ironic that they might now lead to a second wave of bad loans. Little wonder that Southern Weekly draws eerie comparisons with the subprime debt crisis that undid the US banks. The deciding factor, however, will be the scale of their activities: and given the secretive nature of ‘trust-lending’ it’s anyone’s guess how big the problem will become…

Keeping track: As pointed out in WiC53, there is a fear in China of the unhealthy nexus between the banks and the country’s trust companies. As the government seeks to rein in bank lending, more credit is being channelled through trust firms to bypass loan restrictions. According to 21CN Business Herald, the scale of this cooperation had reached Rmb1.88 trillion by the end of A pril. So the bank regulator, the CBRC, has announced it will issue new rules to halt the increase in trust firm lending. It worries that the big banks are using the trusts as an ‘off balance sheet’ vehicle to make risky loans.(25 June 2010)

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