China to overhaul $36 trillion supply chain finance mechanism

BEIJING (CAIXIN GLOBAL) - China is about to rein in its booming, 167.23 trillion yuan (S$36 trillion) market for commercial acceptance bills, a risky, controversial form of business financing that played a role in the 2019 collapse of Inner Mongolia-based regional lender Baoshang Bank.

Stung by that financial calamity, China's central bank and top banking regulatory agency are about to overhaul the 25-year-old regulations governing the bills. The rapid growth in their use in recent years and their involvement in fraudulent financing and other violations spurred regulators to close loopholes and tighten supervision of the instruments.

Feb 14 was the deadline for comments on a draft revision of interim measures issued in 1997 covering commercial acceptance bills, which enable supply chain businesses to monetise their receivables. The revisions are expected to have a dramatic impact on commercial banks, financial companies and commercial acceptance bill issuers and intermediaries.

The new measures stress that commercial acceptance bills should be based on real transaction relations and set the maximum maturity of such bills at six months, down from a year. The draft rules would cap the maximum payment of acceptance bills at 15 per cent of the payer's total assets, and the margin deposit for acceptance bills at 10 per cent of the payer's total deposits at the issuing bank.

Commercial acceptance bills are issued by companies that promise to pay a set amount to the bill's holder on a designated date. The bills are usually used for business-to-business payments but also as a form of short-term trade financing. The payee can choose to hold the bill until maturity and receive payment then, or before the maturity date can transfer it to another party or sell it to a bank at a discount and receive the money in advance.

China's market for commercial acceptance bills expanded 13 per cent in 2021 from the year before, according to the Shanghai Commercial Paper Exchange. Though detailed data is unavailable, industry participants say a significant share of the market is probably financing bills, which have no underlying transactions between the payer and the payee.

Their main purpose is for companies to obtain funding from banks. Another significant portion of the market is arbitrage bills, in which banks issue acceptance bills to obtain deposits, industry participants said.

The new rules aim to restrict the arbitrage use of commercial acceptance bills, which is especially common among medium and small banks, industry participants said.

For example, in a typical arbitrage bill transaction, a company might deposit 10 million yuan in a bank at, say, 4 per cent. The company then pledges the deposit as collateral to issue an acceptance bill, which it sells to the bank at a discount with an assumed interest rate of 3.5 per cent. The business thus would earn 0.5 of a percentage point of interest, and the bank would increase its deposits.

The bank can also rediscount the commercial bills to other banks to make a smaller profit. In this way, the funds continue circulating within the interbank system.

Such practice became rampant in the past decade, peaking between the second half of 2018 and early 2019, several bankers familiar with the industry told Caixin. The Baoshang Bank collapse alerted the central bank to the hidden systemic risks in commercial acceptance bills, according to a bank executive who manages acceptance bill business and who participated in the revision of the rules.

Baoshang, which was 89 per cent owned by private conglomerate Tomorrow Holding, was taken under state custody in 2019 amid severe credit risks. The bank was found to have a financial black hole of 220 billion yuan due to massive misappropriation of funds by its largest shareholder.

The lender relied heavily on the interbank market, where banks borrow from each other and use the funds to bolster liquidity. Before its collapse, Baoshang had only 200 billion yuan of outstanding loans but nearly 300 billion yuan of transactions with more than 700 partners on the interbank market.

A key channel Baoshang used to increase its deposits was trading in arbitrage acceptance bills. The fall of the bank spread the risk to multiple other lenders that had received Baoshang's discounted acceptance bills, according to the executive in charge of his bank's bill business.

At the peak of trading in arbitrage acceptance bills in 2018 and 2019, several lenders in northeastern China generated about 60 per cent of their deposits in this way, a senior bill industry participant said. The volume of arbitrage bills has declined in the past two years, but the new rules will have a greater impact on those banks that previously issued large amounts of them, the senior bill industry participant said.

As of the end of November 2021, commercial acceptance bills accounted for 4.51 per cent of the total assets of domestic banks, far below the 15 per cent limit set by the new rules, according to a research report by Citic Securities.

Eleven listed banks currently have acceptance bill balance greater than 10 per cent of total assets. Among them, only China Everbright Bank and China Zheshang Bank are large banks. The rest are medium to small city commercial banks and rural commercial banks. Bank of Zhengzhou, Qilu Bank and Zheshang Bank exceed the 15 per cent threshold, making them subject to rectification under the new rules.

In terms of the ratio of acceptance bill deposit to total deposits, most listed banks are below the 10 per cent cap, and a handful of banks are at 7 per cent-9 per cent, according to a report by BOC International Securities.

In addition, the new measures clearly stress that commercial acceptance bills must have actual underlying transactions. The proposed rules would increase the penalties for violations.

Where financial institutions receive discounted acceptance bills from issuers without actual transactions, the China Banking and Insurance Regulatory Commission (CBIRC) will be empowered under the revised rules to take regulatory measures such as suspending their bill business or imposing administrative penalties. Directors, senior managers and other persons directly responsible for the violations are to be punished, according to the draft rules.

Banks are expected to strengthen reviews of transactions underlying acceptance bills. For example, some companies with low registered capital and large trade volumes that are unable to provide transport documents and warehouse receipts will find it difficult to pass banks' review, said Zhou Haibin, vice-president at Shanghai Purang Financial Services.

But many of the arbitrage acceptance bills currently in the market are related to big state-owned companies and big publicly traded enterprises with large amounts of trading business, a senior bill business banker said. It will be difficult for banks to tell whether an acceptance bill is for actual transaction payment or for arbitrage, the banker said.

The new rules set the maximum maturity of commercial acceptance bills at six months, shortened from the current one-year limit. Many large companies generally use longer-maturity acceptance bills to extend the payment periods, forcing suppliers to delay collections. This hurts the interests of medium and micro-sized creditors, analysts at Sinolink Securities Co. said.

Another big impact of the new rules will be on intermediaries and brokers that have played an active role in the commercial acceptance bills market.

The new measures set out clear requirements for the qualification of bill brokerage institutions. They must be licensed financial institutions with active bill businesses and good reputations, with an independent bill brokerage department and sound internal control and management mechanism, professional employees and brokerage channels, and they must strictly separate bill brokerage from their proprietary bill business.

When the Shanghai Commercial Paper Exchange officially launched discounted commercial acceptance bill trading in 2019, only five banks - Industrial and Commercial Bank of China, China Merchants Bank, Shanghai Pudong Development Bank, China Zheshang Bank and Bank of Jiangsu - were approved by the central bank as pilot banks to conduct bill brokerage.

Those five brokers are not enough, according to market participants, who said they expect more nonbank financial institutions to apply for bill brokerage licenses.

For years, many unlicensed brokers have been active in the market. Before electronic bills replaced paper bills, banks were reluctant to accept commercial acceptance bills with smaller values, such as 50,000 yuan or 100,000 yuan, due to higher handling costs. Consequently, bill intermediaries emerged. They collected small-value bills from holders and packaged them into larger amounts of as much as 10 million yuan, then sold them to banks to make commissions.

In another scenario, when banks needed to reach a deposit goal at the end of a month, they would issue acceptance bills and sell them to intermediaries at a deep discount. The intermediaries would then sell the bills at a higher price.

In the paper bill era, intermediaries could make money easily. A commercial acceptance bill with a face value of 50 million yuan could bring 8 million yuan of profit for intermediaries, an executive at a supply chain financing platform said.

In the era of paper bills, intermediaries mainly made money due to information asymmetry. In recent years, with the emergence of bill exchanges and online bill trading platforms, the information has become more transparent, and fewer intermediaries directly deal with discounted bills because of smaller profit margins.

Now many intermediaries have transformed into agents for bill trading platforms. When companies need to buy or sell commercial acceptance bills but don't have the resources to do so on the bill platforms themselves, they entrust intermediaries to do it, a person at a bill platform told Caixin.

What the new rules don't apply to that also pose great risks are many types of alternative credit certificates that function similarly to commercial acceptance bills.

A noteworthy problem is the rapid development of multi-level circulation of receivables on supply chain financing platforms built by core enterprises in recent years. These large companies issue electronic credit certificates to suppliers, mostly mid-size to small businesses. These certificates don't have a standard form and are generally called credit letters in the market.

They are basically "IOU" notes issued by companies, a senior bill expert told Caixin. For example, if a large company doesn't pay suppliers' receivables but issues credit letters to them, the suppliers then can transfer these notes to the supply chain financing platform built by the large company.

"Small suppliers have to accept such credit letters," said the senior bill expert. "Otherwise, the large companies wouldn't buy products from them."

There are hundreds if not thousands of such platforms across China that trade electronic credit certificates, the head of a major bill trading platform told Caixin.

At first such platforms were mostly built by central government-owned large enterprises partnering with state-owned banks. Since 2017, after the State Council encouraged the development of online receivables financing and other supply chain financing modes, more and more local state-owned companies and private businesses have built their own platforms.

These credit certificates and trading platforms have a positive effect on the real economy by providing financing to enterprises, but their rapid growth enables large enterprises to keep using money they owe to small and medium-sized suppliers. The accumulation of receivables and stagnant capital flow are important problems in the real economy, especially for small and medium-sized enterprises, said Xiao Xiaohe, dean of Jiuyin Bills Research Institute of Jiangxi University of Finance and Economics.

As of October 2019, the outstanding accounts receivable of China's industrial enterprises above a designated size stood at 17.46 trillion yuan, accounting for more than 20 per cent of the enterprises' core business revenue, according to an article published in the state-run journal China Finance by Kong Yan, vice president of the Shanghai Commercial Paper Exchange. The ratio was in line with the record high of the early 1990s, when "triangle debt" was rampant, the article said. Triangle debt arises when slow sales result in delayed or partial payments and companies end up owing money to each other and to banks.

Due to the natural defects of receivables, the circulation of such credit certificates not only increases the vulnerability of the financial system but also aggravates the plight of small, medium and micro businesses, Kong said.

Such credit certificates are essentially illegal financing activities, which should be subject to unified supervision and regulation, a senior bill expert said.

In September 2020, the central bank and eight ministries jointly issued an opinion stepping up regulatory scrutiny of supply chain financing. The opinion called for preventing various forms of risk in relation to supply chain financing, stipulating that core enterprises can't intentionally withhold receivable funds from upstream and downstream suppliers while using affiliate entities to obtain supply chain financing.

In December 2021, the State-owned Assets Supervision and Administration Commission (SASAC) of the State Council released a notice on cleaning up overdue receivables at medium to small companies, banning central government-owned businesses from issuing commercial acceptance bills and supply chain debt certificates with a maturity more than six months.

This story was originally published by Caixin Global.