China bank IPO shows rewards of financial alchemy

October 24, 2013

By John Foley 

The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Financial innovation is paying off for Bank of Chongqing, a small Chinese lender preparing for a $2 billion stock market listing in Hong Kong. What sets the bank apart isn’t its enviable 32 percent return on equity, but its copious use of what might be China’s most baffling securities.

The instruments, called “trust beneficiary rights”, accounted for nearly two-thirds of Bank of Chongqing’s investment portfolio in the first half of 2013. The interest they paid was equivalent to almost all of the year-on-year increase in the bank’s interest income.

A trust right is created when an intermediary called a trust company makes a loan to a borrower and then sells on the credit risk to a bank. Often the borrower is a local government in need of funds, and the bank doesn’t want to lend to it directly.

Graphic: China’s banks play pass the parcel

Normally, the bank would be exposed to the risk the loan can’t be repaid. To get around that, the borrower gets its IOU to the trust guaranteed, often by bringing in another bank. The first lender can then treat its trust rights like a loan to another bank.

This game of pass-the-parcel brings several benefits. The main one is that the trust right pays a much higher interest rate than an interbank loan. And loans between banks only require the lender to lay aside a quarter as much capital as it would for a corporate loan.

Bank of Chongqing is an ideal buyer of these securities – it has 56 billion yuan ($9.2 billion) of deposits not currently matched by loans. Its holdings of trust beneficiary rights generated a 7 percent yield in the first half of the year, comparable to the rate on company loans, but with less credit risk. The guarantee means it doesn’t even need to vet the ultimate borrower directly.

If the borrower stops servicing its loan, though, a scramble could ensue. Bank of Chongqing would expect the trust to rustle up the funds. The trust would harass the guaranteeing bank, which may not have laid aside sufficient capital to cover the loss, especially if the ultimate borrower has the unofficial backing of a local government.

The loophole is crying out to be closed by regulators. At best they could force banks to limit their exposure, causing earnings to slow. At worst they could reclassify trust rights as corporate loans, requiring banks to hold masses more capital against them. Despite the name, the benefits of this type of financial innovation look hard to sustain.

 

Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/