MNI CHINA ANALYSIS: New Rule To Curb MMFs, Interbank Funding

     BEIJING (MNI) - The new guidelines for money market funds (MMFs) issued by

the China Securities Regulatory Commission (CSRC) last week will help the

financial system to deleverage and prevent potential MMF liquidity risks but

will create further dislocation for smaller MMFs and further limit small bank

funding in the near term. 

     The new CSRC rules underscore Chinese regulators' intention to continue

reining in systemic financial risks. 

     Chinese MMFs have grown rapidly in the past several years, with total

assets under management (AUM) rising to CNY5.86 trillion as of the end of July

from just CNY1.42 trillion in February 2014. MMF growth has been especially

rapid his year, as banks turned to funds offering high yields after new

government restrictions curbed their ability to earn strong returns from

wealth-management products (See MNI ANALYSIS: High-Yield Money Mkt Funds Jump On

Bank Appetite, published August 29). 

     At the same time, the rise in high-yield MMFs pushed up funding costs for

the entire financial system, much to the displeasure of regulators. 

     The latest guideline on MMFs aims to slow their rapid development to help

the financial deleveraging campaign. 

     "The rapid development of MMFs has transformed to some extend (bank)

deposits into interbank deposits, with the latter having a higher cost than the

former," Li Qilin and Zhong Linnan, analysts at Lianxun Securities said in a

report on Monday. "The higher costs of liabilities has caused the asset

allocation behavior of financial institutions to change because they need higher

returns on the asset side, so they increase their leverage, increase their

duration mismatches or seek higher risks."

     "The core of preventing financial risks is to lower the liability costs of

financial institutions and normalize their risk appetites, so it is necessary

for regulators to control the development of MMFs," Li and Zhong continued.

     The new rule restricts the size of some MMFs by limiting the asset value of

those MMFs, whose calculation of net asset value (NAV) is not marked to market,

to no more than 200 times the fund's risk provisions. Those funds found

violating this rule will have their required risk provision increased to 20% of

the MMF's monthly management fee.  

     In the past, MMFs set risk provisions equal to 10% of their monthly

management fees, with total provisions capped when they reached 1% of net asset

value at end of the previous quarter end. 

     The new rule is much stricter.

     "For example, if we use a typical management fee of 0.33% to calculate, a

MMF whose assets under management is CNY303 billion will receive CNY1 billion as

a management fee each year, so it will set aside CNY100 million as provisions"

under the old system, China International Capital Corporation (CICC) explained

in a report published at the weekend. "However, according to the new rule, a

provision of CNY100 million is only suitable for a MMF whose size is CNY20

billion, so the sizes of MMFs are effectively restricted."

     Investments by banks and other financial institutions in MMFs are also

restricted by limiting the size and types of allowable investments. If a single

investor holds more than 50% of a MMF, then the MMF shall either use a

mark-to-market method to calculate its NAV or the liquid assets that the MMF

holds -- including cash, government treasuries, central bank notes, bonds issued

by government policy banks or other financial tools maturing within five days --

must account for more than 80% of its total assets, reducing the potential

return on investment.

     The statement also requires MMFs whose 10 biggest investors in total

account for more than 50% of the fund to have an average portfolio duration no

more than 60 days, with at least 30% of assets of highly liquid instruments. For

MMFs whose 10 biggest investors account for 20% of the total fund, the average

portfolio duration shall not exceed 90 days, with 20% of total assets in highly

liquidity securities. 

     "Banks and insurance companies like to invest in MMFs that buy certificates

of deposit and small amounts of corporate bonds to evade tax and boost returns,"

Huang Weiping, Luo Ting and Tang Yue, analysts at Industrial Securities, said in

a report Monday. "The new rule will lower the return of MMFs and so will curb

the development of MMFs." 

     According to CICC estimates, MMF yields will drop more than 100 basis

points if the new rule were to be applied immediately.

     The new guideline also requires the collateral that a MMF can accept in a

reverse repo transaction be the same as the types of assets in which the MMF

invests, preventing MMFs from accepting low-rated collateral to generate higher

returns. The rule also limits the ability of non-bank financial institutions to

increase leverage by using reverse repos to borrow from MMFs.

     To prevent liquidity risks and promote deleveraging, the new guideline

restricts the range of assets in which MMFs can invest. According to the new

rule, MMF cannot invest more than 10% of total assets under management into

bonds whose ratings are lower than "AAA." The new rule requires deposits and

negotiable certificates of deposit issued by a bank and purchased by a single

MMF to not exceed 10% of the NAV of the bank as of the end of the last quarter.

     "The new rule significantly increases the difficulties for large and small

MMFs to allocate their assets," CICC said. "The MMFs cannot invest in low rated

bonds to boost yields, which will be negative for some small and medium-sized

MMFs that were attractive because of their high yields."

     "It will be harder for small and medium-sized banks to do interbank

borrowing, so the space for them to leverage up will be limited," CICC

continued.

     The new rule also seeks to prevent runs on MMFs, as occurred last November

and December, when banks rapidly redeemed their MMF investments due to

expectations of strict regulation. Several items in the new rule enable MMF to

postpone redemption applications and to charge special redemption fees.

     The short-term impact on the financial system will be limited as the CSRC

is giving MMFs six months to adjust portfolios that do not meet the new

requirements. Most MMFs have short durations, so the impact may not be very

significant.

     Analysts said the new rule will be good for financial system in the

long-term.

     "Stricter requirements on asset allocations, portfolio durations and

concentration levels will enhance the liquidity of MMFs and lower risks," CICC

said. "The yields of MMFs will go down and the MMFs will go back to their normal

role as a tool to help cash management."

     "From the experience in the U.S., stricter regulations will help the

sustainable development of MMFs in the long-term," CICC said.

--MNI Beijing Bureau; +86 10 85325998; email: he.wei@marketnews.com

--MNI BEIJING Bureau; +1 202-371-2121; email: john.carter@mni-news.com

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