By Li Jinnan, Partner, King & Wood’s Banking Group 

The expansion of bank-trust cooperation and the practice of repackaging off-the-book bank loans into trust products for sale to consumers came under unprecedented scrutiny this July as the China Banking Regulatory Commission ordered trust companies to cease all cooperative work with banking organizations.

Recent reports reveal that the complete shutdown of bank-trust cooperation has now been repealed, but the CBRC’s new circular allowing banks to resume cooperation with trust companies has place a number of new conditions on the once burgeoning industry.

The circular focuses on one of the two regular models of bank-trust cooperation. In the first model, commercial banks collect funds from clients through the issue of wealth management products and entrust these funds to trust companies for outside management ("Model A"). In this model the bank’s customers have no direct contact with the trust company.

In cases following the second model, which is not addressed by the circular, trust companies engage banks as a distributor of their financial products ("Model B").

The circular states that "Model A" products should be classed as either finance products or investment products. Under the new regulation, the proportion of finance bank-trust product liabilities must remain below 30% of total outstanding bank-trust liabilities. The circular also states that funds obtained through sale of investment products may not be invested in unlisted companies, although some flexibility may be allowed to encourage investment in developing industries, such as new energy.

The circular will force banks to reduce the volume of credit and quasidebt investment, including classic equity investment with a counterpurchase option, to below 30%, forcing banks and trust companies to look for new ways to maximize profit through investment-class bank-trust products. It will be difficult, however, for trust companies to achieve this goal with the circular’s new restrictions on private equity investments.

It is possible that trust companies may find ways around the new regulation either by creating limited partnerships to act as investment vehicles for funds obtained through the sale of investment-class trust products or by investing in equity-linked products, primarily contractual arrangements involving no actual equity ownership.

Banks and trust companies may also increase sales of “Model B” trust products, which are not addressed in the new circular. The second model, however, will reduce the number of qualified investors able to take part in trust investment. This model may also force banks to reveal their profits to clients.

The circular also stipulates that bank-trust investment products launched prior to the circular’s publication must be shown on bank balance sheets before the end of 2011 and that banks must maintain the capital adequacy ratio for trust products according to the same regulations as applied to loans. The circular states that balance sheet restructuring must be carried out according to a specific set of requirements but does not state the specifics of these requirements. The circular does not address bank-trust investment products released after the publication of the circular, but the regulations are unlikely to be different.

Finally, the circular requires that all trust products must have contracts of longer than one year and prohibits the creation of open-ended finance-class trust products. Before the CBRC prohibited bank-trust cooperation in July, trust products often fulfilled long term financing need through the creation of several short term financing agreements. This process has now been regulated. For example, a three year project may be split into three separate one year financing products, ensuring the timely injection of funds. The new regulated system still retains some risk, however, and if the second and third year products fail to sell, financing for the project may fail.