China's Latest Move To Unwind A $2 Trillion Investment Product Is Bad News For Chinese Banks

Citic Securities, China's largest brokerage, was down 3.7%.

This comes on news that the government wants banks to unwind the controversial wealth management products (WMPs) and switch to asset management plans (AMPs).

WMPs make up the $2 trillion powder keg at the heart of China's banking system.

In a quest for higher returns, tons of people have been pouring their wealth into WMPs, which are sold as high yielding, low-risk investments offering "expected" instead of "guaranteed or promised returns." This flood of deposits is key reason behind the surge in social financing and banks' fee income in recent years.

WMP holders largely view these as "investments as deposits" according to Bank of America's David Cui, while in reality they take the hit if the investments go bad. And it is "this perception mismatch" that "prompts banks to seek undue risks when investing 'other people's money he writes.

This has obviously been unsustainable.

In late 2012, we saw investors take to the streets when WMPs they bought from Huaxia Bank soured.

AMPs on the other hand will only provide investors with a "possible range of returns," and they are open-ended. Initially they will only be allowed to invest in direct debt financing instruments (DDFIs) like securitized bank loans and other such assets, that can be traded on China's interbank market.

So what's the rationale for switching to AMPs?

"The key change is to remove an implicit guarantee of principle and yield, in the form of 'expected return,' by WMPs," writes Cui.

For now, 11 banks are testing out AMPs, but if these are successful, they could have bigger implications on China's financial market. Cui argues that consumers stand to gain while financial institutions stand to lose. This is largely because investors will become more aware of the risks that come with these products, and will therefore be less likely to place their money there. From Cui:

"This probably means that total social financing growth will slow down and hurt investment. Banks' fee income should also suffer: with WMPs, they took a spread between what they pay investors and what they get; with AMPs, they may only be able to book a management fee. The new rules may also eliminate the banks' needs to use other financial intermediates to structure off balance sheet products to satisfy regulatory requirements."

This would also have broader implications for the economy as credit growth would slow, and this would trickle over to sectors that rely on investment.

Of course the success of AMPs is far from certain, as banks are unlikely to be too enthusiastic about this new investment product.