Non-standard debt assets are debt assets not traded in the interbank and stock exchange markets, including, but not limited to, credit assets, trust loans, entrusted claims, acceptance bills, letters of credit, accounts receivable, various types of beneficial rights (rights to yields) and equity financing with repurchase terms. Under the context of financial deleveraging, traditional financing channels have been tightened sharply and the threshold for issuing bonds has been greatly raised, while financing methods using non-standard asset-management products, such as trusts, have risen rapidly.
The China Banking and Insurance Regulatory Commission released on its website the Beijing Banking Regulatory Bureau’s decision to punish two trust companies within its jurisdiction in June 2018. The punishment was for not identifying downward the authenticity and compliance of the underlying assets, according to the principle of “penetration”. So, it is evident that the regulators’ supervision of the underlying assets has become increasingly strict, though unified standards for such reviews are still lacking. The review boundary is still widely being discussed in the industry.
Generally, underlying assets result from the penetration of basic assets. In the case of uncomplicated basic assets, such as accounts receivable, these are underlying assets. However, funds, trusts and wealth-management products are all “packaged” asset-management products. Underlying assets, backed by such basic assets, are relatively complex.
The Notice on Issues, including Enhancement of the Registration Elements of Financial Information in the Banking Industry, clearly defines, for the first time, the types and definitions of underlying assets mainly comprising financial assets and divides the underlying assets into 15 categories. The top 14 categories are still in use and comprise cash and bank deposits, money-market instruments, bonds, direct-financing instruments, new investable assets, non-standard debt assets, equity assets, financial derivatives, overseas financial-management services for clients, commodity assets, alternative assets, public funds, private funds and industrial-investment funds. The classification of the underlying assets, in which other funds invest, is not clearly defined and can be determined based on the aforementioned categories. For non-standard asset-management products, underlying assets mainly include trust loans, entrusted claims, accounts receivable and beneficial rights (rights to yields).
To avoid the risk of underlying assets having an adverse impact on asset-management products and, as a result, damaging the rights and interests of investors, as well as to rectify regulatory arbitrage and other chaos of the asset-management business, regulatory authorities generally require financial institutions to examine underlying assets on the principle of “penetration”. These requirements are clearly reflected in the previous regulatory norms of the China Banking and Insurance Regulatory Commission and the CSRC and are becoming more stringent following the promulgation of the Guiding Opinions on Regulating Asset Management Business of Financial Institutions (New Rules for Asset Management).
Although the New Rules for Asset Management do not specify “penetration”, they do prescribe the investment requirements for non-standard debt assets, eliminate multi-layered nesting, emphasize the establishment of uniform standards for regulating multi-layered nesting, unclear leverage, serious arbitrage, frequent speculation and other issues of the asset-management business. Basically, all these indirectly reflect regulatory requirement that financial institutions review underlying assets. However, there is no further clarification in the current regulations on how to “penetrate”. It is inevitable that, without specific rules or norms, financial institutions are in the dark in carrying out their asset-management businesses and have a certain comprehending deviation in the standards of underlying asset review.
Although regulators have not formulated uniform standards for the extent to which financial institutions should review underlying assets, in terms of asset securitization, the Guidelines for Due Diligence of Asset Securitization Business of Subsidiaries of Securities Companies and Fund Management Companies require that managers must conduct due diligence on the legal ownership, legality of transfer, operational status and cash flow of underlying assets. The guidelines have certain reference significance. The authors believe, in conjunction with the recent provisions on due diligence in the Guidelines for Due Diligence of Fiduciary Responsibility of Trust Companies, that the so-called “penetration review” means financial institutions should, at least, verify the authenticity, legitimacy and transactional compliance of the underlying assets.
As far as the authenticity and legitimacy of underlying assets is concerned, taking accounts receivable as an example, it is necessary to verify if there is a real and legitimate trading background, determine whether the underlying assets are legally formed and confirm legal ownership through review of relevant transaction vouchers. It is also necessary to verify the status quo, operation and cash flow of the underlying assets to determine whether the underlying assets are in a legal and valid state of existence.
As far as the transactional compliance of the underlying assets is concerned, different regulations apply depending on the category and industry where they are located. Therefore, appropriate and applicable regulations should be applied, in combination of various norms and on diligent reviews based on the different types of asset-management products. For example, with respect to trust products, if a trust loan is issued to a property developer, the underlying assets need to meet regulatory requirements, such as “complete documents, at least 30% project capital of the real estate company, level 2 and above development qualifications of the financing party”.
Underlying assets are related to the final flow of funds. Regardless of the regulatory orientation of “radical reform” or internal risk controls of financial markets, high requirements are imposed on underlying asset reviews. Such reviews require an overall grasp, that is “find a significant trend with a small sign”, to get a clear picture of the underlying assets. The non-standard asset-management products built, based on the underlying assets of authenticity, legitimacy and transactional compliance can have a solid foundation for risk prevention.
Yao Xiaomin is a partner and Wang Meilin is an associate at Lantai Partners
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