By Gabriel Wildau and Shengnan Zhang
SHANGHAI (Reuters) - China will launch a pilot programme next week aimed at shattering a widespread assumption among Chinese investors that products, even high-yield ones, provide guaranteed returns when offered by state-owned banks, sources said.
For years, many Chinese treated their investments in so-called wealth management products, many of which offered enticing returns, as tantamount to a deposit with a guaranteed yield, even if that was not the case.
Policymakers have warned that such a high level of moral hazard has been built into the wealth management industry that if a product failed to payout as promised, banks would face enormous pressure to compensate investors, even if they were not legally required to do so.
Investors protested outside a branch of Hua Xia Bank <600015.SS> late last year when a product it had distributed failed to pay out on maturity.
"The key change is to remove an implicit guarantee of principle and yield, in the form of 'expected return,' by wealth management products," David Cui, equity strategist with Bank of America-Merrill Lynch in Hong Kong, said in a client note.
"Currently, most wealth management product buyers view their investments as deposits while, legally speaking, they bear most of the downside if investments go bad."
Wealth management products have soared in popularity in recent years as an alternative to investment in real estate, volatile stock markets and state-set deposit rates. Most are short-term savings vehicles often created by third parties but issued through banks.
The rising popularity of the opaque products have sparked concerns of a credit binge directing money into increasingly speculative investments, which analysts say could pose a risk to the financial system.
Because many of the products were sold through state banks, investors assumed that meant they were backed by the government and so were 100 percent safe, even if the product's documents spelled out that principal and returns were not guaranteed, bankers said.
Under the pilot project, the China Banking Regulatory Commission (CBRC) will allow 11 banks to sell asset management plans directly to customers, two bankers with direct knowledge of the programme said.
The approved banks include Industrial and Commercial Bank of China <1398.HK> <601398.SS> and China Construction Bank <0939.HK> <601939.SS>, China's two largest banks by assets, as well as Bank of Communications <3328.HK> <601328.SS>, the fifth largest.
"There is no firm legal basis for banks to do direct financing, or at least it's very weak. So they have to start with a pilot programme and move gradually," said a banker involved in the pilot.
TINY QUOTAS UNDER PILOT PROGRAMME
The project will not allow banks to assign an expected return to a product, common in wealth management investments, and one reason they were seen as guaranteed.
Unlike wealth management products, they will also be forced to regularly publish a net asset value to reinforce the idea that returns are based on the performance of the asset, not the creditworthiness of the bank.
Detailed rules have not been released, but bankers said they expected them to require banks to clearly identify the underlying assets of a product.
The rise of the wealth management industry has led to increasingly complex investments. In many products, the underlying asset was often an opaque trust fund or brokerage product, providing little clarity on the identity of the ultimate borrower.
The assets in a wealth management product were also often a package of loans from the bank selling the product to investors. It would collect a portion of the interest income from the loans, blurring the lines between on-and off-balance sheet assets.
Banks also often provided guarantees - sometimes informally - to their trust and brokerage partners, promising to compensate the third party for losses or to repurchase credit assets at a future date.
Indeed, the nasty cash crunch that roiled China's interbank lending market in late June, was due in part to banks' need for cash to fund payouts on maturing wealth management products that were supposedly off-balance-sheet.
CBRC Chairman Shang Fulin said recently that China's wealth management industry needed to move towards a pure asset-management model in which the bank connects borrowers with investors - collecting a management fee in the process - but plays no role in guaranteeing returns or sharing income from the assets they manage.
Under the pilot programme, banks will be required to strictly segregate on- and off-balance sheet funds.
While regulators want a business model akin to mutual funds to become the norm for banks' wealth management business, the initial size of the new pilot is tiny.
Most of the 11 lenders will receive initial quotas between 500 million and 1 billion yuan ($82 million to $163 million), though a few may get larger quotas, the bankers said. That compares to 9.08 trillion yuan in bank wealth management products outstanding at the end of June, CBRC figures show.
The other banks included in the pilot project are: China Merchants Bank <3968.HK> <600036.SS>, Minsheng Bank <1988.HK> <600016.SS>, Everbright Bank <0165.HK> <601818.SS>, CITIC Bank <0998.HK> <601998.SS>, Ping An Bank <000001.SZ>, Shanghai Pudong Development Bank <600000.SS>, Industrial Bank <601166.SS>, and China Bohai Bank
(Editing by Neil Fullick)