By Lu Jianxin and Gabriel Wildau
SHANGHAI (Reuters) - China's central bank published rules on Thursday governing investment by wealth management products (WMPs) in the country's bond market, in a move aimed at containing risks posed by banks' off-balance-sheet business.
WMPs are short-term investment products that banks market to customers as higher-yielding alternatives to traditional deposits.
In principle, banks simply manage WMP assets on behalf of clients, with the client, not the bank, exposed to losses if the assets decline in value. But analysts warn that China's banks' are increasingly exposed to the loans, bonds and other off-balance-sheet assets underlying WMPs.
That is due in part to the maturity mismatch between short-dated WMPs and longer-dated bonds and the loans that underlie them. This mismatch often forces banks to use their own funds to make cash payouts on maturing WMPs when the underlying assets have not yet matured.
At the end of September, outstanding bank WMPs were 9.9 trillion yuan ($1.63 trillion), according to China's bank regulator, though interbank bonds comprise only a portion of that total.
The new rules are designed "to standardize investment by commercial banks' WMPs in the interbank (bond) market and protect the interests of various sides," the People's Bank of China (PBOC) said in the new rules published on the website of the central bank-backed National Interbank Funding Center.
Regulators are especially concerned about banks moving assets between their own balance sheets and off-balance-sheet WMP accounts based on which entity needs cash at a given moment.
"A common practice is that banks use proprietary funds to cover up a temporary shortfall in a WMP's account and vice versa," said a bond trader at a Chinese commercial bank.
"That creates potential risks to banks' own assets and irregularities such as 'tunneling' of interest," he said, referring to arrangements in which a bank collects a portion of the interest income from bonds or loans, even when those assets aren't recorded on-balance-sheet.
The PBOC's rules aim to curb this risk by forcing banks to strictly segregate on- and off-balance-sheet assets.
The rules say that commercial banks that invest WMP funds in bonds traded on the Shanghai-based interbank market must establish separate accounts for each product, with only a handful of exceptions, such as when a product is managed by several banks.
Within three months of applying to PBOC's Shanghai headquarters to establish a WMP account, banks must connect the account to the interbank market's computer system and begin using that account to trade and settle bond trades by WMPs, according the rules dated January 26, which take effect immediately.
The notice was first issued to 16 top Chinese banks, including the Big Four state-owned banks, signaling that these institutions will be the first to win approval to establish the WMP accounts required under the new rules, the trader said. PBOC officials were not immediately available for comment.
The new rules also set minimum requirements that banks must meet in order to open WMP accounts to trade bonds in the interbank market. Banks must have asset-management licenses, and officials in charge of the WMPs must have relevant certifications.
Bond trading accounts used for existing WMPs must apply for re-registration within one year. Those that fail to meet the new requirements must gradually divest their bond holdings, according to the rules.
About 94 percent of China's domestic bonds are traded in the interbank market, with the remainder traded on the country's stock exchanges. ($1 = 6.0624 Chinese yuan)