OREANDA-NEWS. Decisions announced on 16 January by China's securities and banking regulatory commissions to curb margin lending and better regulate entrusted lending, highlight some of the risks related to corporate governance in the country's financial sector, says Fitch Ratings.

In particular, the decision by the China Securities Regulatory Commission (CSRC) to fine 12 brokers for violations of margin lending rules and impose a three-month ban on opening new margin accounts for three brokers indicates that even where regulations are in place, they may not be strictly adhered to by market participants, including market leaders.

There has been substantial growth in margin lending since it was first allowed by the CSRC in 2010. Following an increase in excess of CNY700bn since June 2014, the margin balance reached CNY1.1trn as of 16 January. This rapid rate of growth flags a potential source of unexpected credit and operational risks to securities firms operating in an underdeveloped market where regulations are evolving. This is especially the case as the Chinese brokerage industry has yet to prove capable of managing the effects of acute stress to some margin borrowers that would be brought on by a period of extreme market volatility.

The development of securities (margin) financing, is a natural evolution toward a deeper capital market. However, with limited experience and weak corporate governance, the business could overly stretch securities firms' funding and capital in a relatively short period of time. Margin finance now accounts for 10-15% of leading securities firms' revenues, while its rapid growth has also led to a marked increase in brokers' leverage.

As such, though the CSRC curbs come at the expense of securities firms' revenue growth, it may protect brokers against potential systemic losses resulting from a sharp and sustained market correction.

The CSRC decision also has implications for banks. Brokers' risk profiles can be highly correlated with that of banks owing to their reliance on wholesale funding from banks and involvement in managing bank-consigned wealth management products.

For banks, the CSRC decision is negative for share prices in the short term as they are among the top investments for margin borrowers. Tighter monitoring over margin lending may also raise asset quality risks if an abrupt equity market correction exposes risks and accelerates the surfacing of bad debts. However, the medium-term credit impact should be limited with the curbs having only a neutral or slightly negative effect on earnings.

As part of the broader curbs on margin lending, the China Banking Regulatory Commission (CBRC) has also initiated a draft consultation over the management of entrusted loans at commercial banks. Fitch estimates that entrusted loans, which are off balance sheet and organised by an agent bank between a borrower and lender, amount to CNY11trn as of December 2014. The agency also highlights that some of these entrusted loans may have been invested in the stock market, where short-term risks will have risen on recent volatility. However, it is unclear how much of these entrusted loans have been invested in equities and/or wealth management products.

According to the CBRC draft, entrusted loans should be clearly defined as a commission-based agency business to commercial banks only, and that banks should not assume any credit risks relating to these loans. Further, the draft stipulates that entrusted loans should properly state the source of funding and that loan proceeds should be used in policy-supported areas and are restricted from use for investments in bonds, derivatives, stocks, wealth management products or restricted projects/industries.

In the longer term, more robust regulations and strict adherence to these regulations by market participants should limit leverage in the financial system. Clear segregation of risks should also improve information disclosure over some of these fast growing asset classes in China.