The rapid evolution of China's financial industry has captured the imagination of global investors. The country already boasts the world's biggest banks by market capitalisation. Early this year, Beijing announced long-awaited plans to bring more depth to its stock market by introducing index futures, margin trading and short selling.
Somewhat neglected in this maelstrom is the trust sector. An industry with a chequered past, it is now being used as a testing ground by Chinese regulators eager to promote asset management as well as alternative methods of financing to reduce the economy's reliance on bank lending.
What are trust companies? In China, the question is difficult to answer. These organisations are variously referred to as trust banks, trust companies, trust & investment companies and trust fund managers. All of these names hold some truth to them, since these uniquely Chinese financial institutions combine the characteristics of various areas of the financial services sector, including private equity, insurance, asset management and banking.
Further complicating an easy definition of trust companies is the fact that they are ever-evolving entities. China’s economic and regulatory environment can precipitate significant changes in their profit drivers and business models in the space of a year. Chinese trust companies are very opportunistic in nature and will roll out new services in response to a market change or need.
A popular saying among trust companies is that, unlike banks, which will only perform a service if it is explicitly permitted, they will perform a service as long as it is not forbidden.
It is therefore no surprise that one trust company can have a completely different business model and profit drivers compared with another trust company. While some trust companies still largely play their historical role as specialised investment channels for local government infrastructure projects, others are looking to develop Real Estate Investment Trusts (REITs) that can be listed in Hong Kong and invest in overseas equities.
Some trust companies are highly reliant on proprietary income, which in some cases represents over 90% of total income, while others derive their revenue primarily from fees and commissions. High proprietary investment in the domestic stock exchanges in 2008 led to significant losses for many trust companies across China.
What is clear, though, is that trust companies play a valuable role in China’s financial sector. From a fund management perspective, they can offer customised, highly structured fund products with access to a wide selection of asset classes, including hard-to-access sectors such as private equity, real estate, infrastructure and alternative investments, to high net worth individuals and institutional investors; trust products are prohibited for distribution to the wider retail market.
They can also provide very timely and flexible financing solutions to clients, both foreign and domestic, that are unable to secure more conventional funding or that would be better served by a customised financial solution. Examples include bridge financing, mezzanine financing, debt-to-equity swaps, factoring and financial leasing. In many cases, services are tailor-made on a project by project basis.
This has made trust companies an invaluable source of financing for small and medium sized enterprises (SMEs) in China, who are often underserved by the banks. Trust companies are more capable of working around the difficulties of lending to SMEs since they are better able to price for risk and assess hard-to-value assets such as machinery and intangible assets. They do not fear taking risks as long as they can manage those risks.
Following the reform by the China Banking Regulatory Commission in 2007, trust companies are also able to apply for a wider range of licenses, allowing them to engage in many new business lines including securitisation, infrastructure and real estate funds for insurance companies, REITs, enterprise annuity plans, and QDII (qualified domestic institutional investor) funds.
Risks and Rewards
The attraction these entities possess has not gone unnoticed and both domestic and foreign financial institutions have taken a keen interest in this sector. For trust companies, a strategic partner can bring much needed risk management technology and know-how as well as valuable capital.
Some trust companies have successfully used their relationship with their strategic investor to expand their distribution network, develop new client bases as well as leverage specialised industry knowledge. For financial institution investors, trust companies provide a highly complementary platform to their existing business operations. In particular, the need for higher return, more diversified trust products in the private banking sector has been keenly felt. For other investors, they offer a route into infrastructure finance and real estate investment.
However, the challenges facing the trust sector are considerable and competition between both themselves and other financial institutions is fierce. Likewise, the very nature of their business and the inherently higher risk profile they possess brings them into more frequent conflict with the regulatory authorities, who release various notices and regulations on them on almost a monthly basis.
The level of risk management and corporate governance within these entities also lags behind their peers in the securities and banking sector. Nonetheless, it is to be hoped that the trust sector can rise to these challenges and come up with innovative solutions to these and other problems, as it has in the past.
About the Author
Jason Bedford is a manager in the financial services practice of KPMG in Beijing. If you have any questions about this article or would like to receive a copy of KPMG’s upcoming report on trust companies in China, please feel free to contact [email protected]