China issues draft rules restricting entrusted lending, on top of crackdown on margin finance

SHANGHAI (Reuters) - China's banking regulator has issued draft rules to tighten supervision of entrusted loans, a kind of shadow banking product, in a move seen targeting excessive leverage used to speculate on stocks.

The move follows an announcement on Friday that regulators would crack down on excessive margin finance by certain brokerages, and Chinese stock markets plunged on Monday morning as regulators signalled concern about valuations in the wake of a massive stock rally in the fourth quarter.

The CSI300 Index opened down 6.1 per cent on Monday, and futures tracking the index also dived as investors sold off shares in index heavyweight banks and brokerages.

"The impact of industry overcapacity, local government debt, shadow bank and property risk on the capital markets is not negligible," China Securities Regulatory Commission chief Xiao Gang said in a report on the CSRC website. His comments were made in a speech at an industry conference in Beijing last week.

"The scale of margin trading has grown rapidly, exceeding 1 trillion yuan by the end of 2014, with trading leverage rising obviously. Some brokerages have borrowed short-term money but lent as long-term loans, facing relatively high liquidity risk."

Entrusted loans - a form of inter-company loan in which one firm serves as the ultimate lender and records the loan asset on its balance sheet while banks act as intermediaries and collect a fee - have become an alternative channel to margin lending from brokerages.

Such loans are considered a potential risk to banks given the revolving nature of bank credit and borrowers, in which entrusted loans can be used to generate fresh bank credit in some cases.

The draft rules issued by the China Banking Regulatory Commission (CBRC) for public comment late on Friday states that five categories of funds must not be used for entrusted loans, noticeably bank lending to companies and funds those companies have raised from other investors.

The public has up to Feb. 16 to suggest amendments to the rules.

Entrusted loans are just one of several channels through which non-financial firms offer credit to one another. Other methods include corporate discounting of bank acceptance bills, as well as corporate purchases of trust products, which are usually backed by high-interest corporate loans.

Funds of entrusted loans typically flow into risky assets such as property and stocks more than other forms of shadow banking businesses.

"One of the key drivers behind the recent bull market in China is the rapid rise in leverage ratio as evidenced by surging margin trading activities," OCBC economists said in a research note on Monday. "The total outstanding of margin trading account in both Shanghai and Shenzhen reached a record high of CNY1.19 trillion as of last Friday, up significantly from CNY403 billion at the end of first half of 2014," OCBC said.