While preventing a systemic crisis in coping with failing trust products should be a priority, indiscriminate bailouts would merely delay the inevitable and leave a bigger blowup in a year. In resolving the current problems, the central government must deal with two evil forces that are poisoning China’s financial system: moral hazard and adverse selection.
The banks that distributed the problematic trust products must be held responsible. Their sales commissions are too high to suggest that they are just neutral brokering agents. Indeed, investors bought such products mostly due to the reputation of the distributing banks. Trust companies, while less guilty than the banks, are complicit too because they often know how unreliable the borrowers are. The banks and the trust companies should be liable up to 5 to 10 times their commissions and not more than the principal.
Investors should know that high interest rates mean high risk. They blindly believe in the opinions of sales agents and their verbal guarantees. They should be liable for the remaining losses.
Such an arrangement would minimize the wholesale exit of investors from viable products. As commissions are often low in high-quality products, the exit may prompt more losses than waiting it out. A fair compensation scheme for bad trust products should prevent a systemic crisis.
The Bailout Expectation
High interest rates come with high risk. This common sense is the foundation of the credit market. However, bad money driving out good is a natural force in finance. Unless sound, prudent regulations and healthy financial intermediaries dominate the market, a race to the bottom is inevitable. China’s financial system is very young. While the prudent regulations are all there, the enforcement capability is underdeveloped. This is why bad money driving out good has become such a big factor, especially in the shadow banking system, like the trust product industry.
While there are numerous trust companies, this industry could not have taken off without big banks entering the picture. In a few short years, the trust industry has risen from nothing to 10 trillion yuan in assets. The distribution power of big banks made this possible.
The banks became involved to increase income from fees. As their lending capacity became constrained by capital and sometimes government directive, they embraced trust products as the main off-balance-sheet vehicle to increase lending to their high-risk clients. These clients are usually willing to pay high fees. The banks could charge 4 to 8 percent commission on such products. When the products mature in, say, three years, they need to be rolled over. The banks could get 4 to 8 percent again.
Some trust companies are big and have distribution power. Most, I believe, are vehicles at the service of big banks. They charge a commission, too, though it is much smaller than the banks.
The adverse selection problem begins with who is willing to pay such high fees and high interest rates at the same time. Let’s say the interest rate is 10 percent. The product is for three years. The commissions for banks and trust companies total 10 percent. The borrower gets 90 percent of the loan amount for a 30 percent interest payment over three years. Few businesses in China earn such a high return. The trust loan borrowers, mainly mining companies and property developers, often have greenfield projects. Their future depends greatly on the macro environment. The borrowers essentially gamble with other people’s money.
When one is willing to gamble on a project with a high-cost trust loan, it is usually not a great project. Otherwise, it would have gotten cheap funding. Marginal projects are more likely to go to the trust market. The trust industry essentially attracts people who are likely to go bankrupt.
Why would the banks develop this market? Short-term profit is the motivation. The incentive structure within China’s financial system has a significant bonus component. It is linked to one’s short-term performance. The same force led to the United States’ financial crisis in 2008. What I have heard over the past few years is that there was widespread consensus that the trust industry would eventually become a big mess. However, it kept going because it was in everyone’s interest.
The people who should be most concerned are investors who, in theory, are on the hook. This is where China’s unique financial system comes to play. Almost all significant financial institutions are government-owned, even the trust companies. They carry the aura of government support. People’s faith in the financial system is a major stabilizing force. But, when manipulated by certain players, it could lead to a huge mess, like the trust market.
There is little doubt that the sales people at most state-owned banks misrepresent the facts to potential clients. These people essentially use government credibility to drum up sales to maximize their bonuses. Not all investors are fooled. But they still go in, believing that (1) the banks could not afford not paying because of the social consequences, and (2) that the government would not let the banks fail because of the macroeconomic consequences. The investor market essentially functions on moral hazard.
The trust market has prospered on adverse selection in the borrowers market and moral hazard in the investor market. It is a recipe for rapid growth and a huge disaster down the road. It appears that the tipping point is here, as the mining industry and property market falter.
*Read the full article at Caixin.
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