0bed7b6cf11c. Breaking News. Deutsche Bank Markets Research. Industry Chinese banks. Date 20 November Asia Hong Kong. Banking / Finance Banks

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1 Deutsche Bank Markets Research Asia Hong Kong Banking / Finance Industry Date Breaking News Asset Management Guideline Reshaping China s shadow banking Long-awaited asset management guidance, a long-term positive for China China released the consultative draft for The Guideline on Asset Management Businesses. Targeting the fast-growing asset management sector, an essential part of shadow banking, it proposes capping leverage, reducing duration mismatch, cutting down SPV layers and removing implicit guarantees. We view it as a vital step in continuing financial deleveraging. Near term, we see limited impact on liquidity, as the regulations are largely expected and there is a 19m grace period. But, we see it as a L/T positive, as it raises transparency and caps the growth in shadow banking. We expect divergent impact on banks, as it favours big banks while adding pressure to smaller ones. How big is the asset management sector and what are the key risks? China s asset management sector includes asset management plans issued by different financial institutions. According to the PBOC, total AUM amounted to Rmb102tr as of 2016 (or 137% of GDP), or 50% CAGR since We estimate the credit channeled through the asset management sector has contributed 80% of shadow banking credit, or c.18% of system credit. While it supported economic growth, the proliferation of the asset management sector does come at a cost, with key risks including: 1) liquidity risks due to duration mismatch; 2) contagion risks given multiple layers of SPVs and rising leverage; 3) under-capitalization and under-provisioning; and 4) implicit guarantees, which lift the actual risk free rate and deepen moral hazard issues. What are the proposed measures to reduce risks? This new regulation standardizes product classifications regardless of regulatory regimes, splitting asset management products into publicly-raised and privately-raised ones. Next, based on the new product classification, the regulation stipulates: 1) stop asset-pool operation and lengthen duration of funding; 2) to cap leverage in both borrowed money and product tranches; 3) to cap layers of SPVs; 4) to limit investment in non-standard credit assets by publicly-raised funds; 5) to strengthen capital and provision charge requirement; 6) to encourage NAV-type products and prohibit implicit guarantees. This is a high-level guideline; we expect more detailed regulations. What are the implications for the entire financial system? This is the first regulation targeting the entire asset management sector and is issued post establishment of the Financial Stability Development Committee. So, it suggests that regulatory coordination has been strengthened, which should help curb the regulatory arbitrage of shadow banking by closing loopholes and reducing regulatory competition. This may lead to slower shadow banking growth and reduce the murkiness. Also, it should drive down banks WMP yield, which help lower the actual risk free rate. This is why we see it as a long-term positive. In the near/medium term, we expect: 1) credit growth to moderate, slowing system leverage build-up; 2) banks WMP and NBFIs AUM to slow or shrink; and 3) banks asset growth to slow. What are the implications for individual banks? With elevated shadow banking exposure and lower degree of compliance, smaller banks are likely to face persistent capital and earnings risks. As WMP yield might fall, it would become harder for them to grow deposits thus adding funding pressure. In contrast, big banks should benefit from better loan demand and stable deposit growth. We prefer big banks over the smaller ones. Deutsche Bank AG/Hong Kong Hans Fan, CFA Jacky Zuo Research Analyst Research Analyst (+852 ) (+852 ) hans.fan@db.com jacky.zuo@db.com Edward Du Research Associate (+852 ) edward.du@db.com Top picks Bank of China (3988.HK),HKD3.78 Agri. Bank of China (1288.HK),HKD3.62 China Construction Bank (0939.HK),HKD6.81 Source: Deutsche Bank Companies Featured Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity Distributed of on: this 19/11/2017 report. Investors 20:45:33 should GMT consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 083/04/2017. THE CONTENT MAY NOT BE DISTRIBUTED IN THE PEOPLE S REPUBLIC OF CHINA ( THE PRC ) (EXCEPT IN COMPLIANCE WITH THE APPLICABLE LAWS AND REGULATIONS OF PRC), EXCLUDING SPECIAL ADMINISTRATIVE REGIONS OF HONG KONG AND MACAU. 0bed7b6cf11c Buy Buy Buy ICBC (1398.HK),HKD6.19 Buy China Construction Bank Buy (0939.HK),HKD6.81 Agri. Bank of China (1288.HK),HKD3.62 Buy Bank of China (3988.HK),HKD3.78 Buy Bank of Communications Buy (3328.HK),HKD5.82 China Merchants Bank Hold (3968.HK),HKD31.30 China CITIC Bank (0998.HK),HKD5.02 Hold China Minsheng Bank (1988.HK),HKD7.51 Hold CEB (6818.HK),HKD3.66 Sell Chongqing Rural Bank (3618.HK),HKD5.31 Hold Huishang Bank (3698.HK),HKD3.95 Sell Bank of Chongqing (1963.HK),HKD6.16 Sell Shanghai Pudong Bank Hold ( SS),CNY12.78 Ping An Bank ( SZ),CNY13.18 Hold Industrial Bank ( SS),CNY17.35 Sell Bank of Beijing ( SS),CNY7.44 Buy Bank of Nanjing ( SS),CNY8.13 Sell Bank of Ningbo ( SZ),CNY17.90 Sell Source: Deutsche Bank We value using a threestage GGM (PV= (ROE-g)/(COE-g)), with target prices based on 2017E book values. Downside risks: large-scale DES on government intervention, overtightening and property price correction. Upside risks: SOE reforms and removal or softening of GDP targeting.

2 Asset Management Guideline Reshaping China s shadow banking Overview of China s asset management sector After market close on 17 November 2017, China s five regulators, including PBOC, CBRC, CIRC, CSRC and SAFE, jointly released the long-awaited consultative draft for The Guideline on Regulating Asset Management Businesses of Financial Institutions. It aims to standardize the regulatory requirements across various asset management products, to contain financial risks and to direct lending to support the real economy. We believe this regulation is going to reshape China s shadow banking How big is the asset management sector? According to PBOC, China s asset management industry includes: (1) banks on & off balance sheet wealth management products; (2) brokers asset management schemes; (3) trust investment schemes; (4) public mutual funds; (5) fund and fund subsidiaries investment schemes; (6) private funds; and (7) insurance investment funds. What differentiates China s asset management sector from others is that it is an essential part of shadow banking in China. Total AUM of asset management industry came to Rmb102tr as of end-2016 (or 137% of GDP), or Rmb60-70tr if stripping out the overlap among these subsectors, e.g. banks entrusted some of their assets from WMP to brokers investment schemes to invest in some other non-standard assets. We calculated total AUM of asset management industry posted a CAGR of 50% in , as shown in Figure 1. This is much faster than total system loan CAGR of 14% in the same period. Among those assets, banks WMPs made up a meaningful weighting of 27% of total AUM in 1H17, followed by trust investment schemes (18%) and brokers asset management schemes (17%). Figure 1: Asset management industry AUM CAGR came to 50% in Asset management industry AUM CAGR at 50% in H Private funds Insurance Investment Fund Fund and fund subsidiaries' investment schemes Public mutual fund Trust investment schemes Brokers asset management schemes ' WMPs CAGR Breakdown in 1H17 119% 21% 69% 42% 29% 129% 45% 13% 2% 14% 9% 18% 17% 27% Source: Deutsche Bank estimates, PBOC, CBRC, CSRC, AMAC, Trust Association, CIRC, Caixin Page 2 Deutsche Bank AG/Hong Kong

3 Who are the funding providers and how are the funds used? We have collected financial data of funding sources and underlying assets for each type of asset management product. Fundingwise, as of year-end 2016, financial institutions provided 51% of funding, the majority of which we believe are commercial banks. This is followed by individual investors (31%) and corporates (18%). Underlying asset wise, non-standard credit asset represented 36% of total AUM, which are mostly loan-like fixed income assets. Bonds represented 29% of total investment, followed by deposits and money market funds (15%), equity and other securities (7%) and mutual fund (2%). Putting this into context of the entire system, if we account non-standard assets and bonds as credit, then China s asset management sector contributed more than 80% of shadow banking credit, or approximately 18% of total system non-financial credit. Figure 2: Funding source versus underlying asset of asset management sector Funding Source China's asset management sector Underlying Asset Retail investors (31%) Total asset management industry AUM at Rmb102trn as of end-2016; or Rmb60-70trn if stripping out overlap. Insurance investment schemes (1.7trn) Deposit and money market fund (15%) Bond (29%) Corporates (18%) Public mutual fund (Rmb9.2trn) Brokers' AM schemes (Rmb17.6trn) Bank's WMP (Rmb29trn) Private funds (Rmb10.2t rn) Trust investment schemes (Rmb17.5trn) Equity and other securities (7%) Mutual fund (2%) Financial institutions (51%) Fund and fund subsidiaries' investment schemes (Rmb16.9trn) Non-standard asset (36%) Others (11%) Source: Deutsche Bank estimates, PBOC, AMAC, Trust Association, CIRC, CBRC, Blue Book of Asset Management 2017 Note: The size of squares represents the size of AUM. How did we get here, with such a notable asset management sector size? In our view, the root cause of the proliferation of asset management AUM was mainly due to GDP targeting and fragmented regulatory framework. With a difficult to achieve targets of a certain level of GDP growth, local governments and banks have strong incentives to grow loan books. However, the fast-growing lending contradicts the tight regulations faced by banks, including capital rules, loan quota and a cap on loan-to-deposit ratio. This creates rising financial innovation via various asset management plans to bypass those regulations. The regulatory framework in China has been fragmented, as there has been a lack of sufficient communications and coordination among the four financial regulators in the past, as shown in Figure 3. As such there were loopholes, which allowed financial institutions to conduct Deutsche Bank AG/Hong Kong Page 3

4 regulatory arbitrage activities. In some instances, there was even competition between regulators, leading to aggressive expansion in some asset management products. Figure 3: China s fragmented regulatory framework in the past China s regulatory framework on asset management businesses (in the past) PBOC Monetary policy Macro-prudential assessment CBRC CSRC CIRC WMP (Rmb28tr) Brokers AMPs (Rmb18 tr) Insurance investment funds (Rmb1.9tr) Fund and fund subs AMPs (Rmb15tr) Trust plans (Rmb20tr) Public mutual fund (Rmb10tr) Private funds (Rmb9.5tr) Source: Deutsche Bank, CBRC, CSRC, CIRC, PBOC Note: The size of squares represents the size of AUM A little history of shadow banking Hide-and-seek The Chinese regulators were not unaware of the growing shadow credit. Actually they have rolled out several regulations to tighten the risk controls in previous years. However, the underlying root causes we mentioned above were not addressed. So, at each new announcement, banks were always able to come up with new ways to circumvent the then-existing rules. We summarize previous regulations in below: Circular 237 on interbank entrusted payment (August 2012): The typical model of interbank entrusted payment is that banks book nonstandardized credit assets (NSCAs) under interbank assets with letters of credit issued by other banks as collateral. As such, they could charge only 20% risk weights and bypass the loan quota. In August 2012, the CBRC released Circular 237, which requires the entrusted bank to book interbank entrusted payments under the loan category and thus the risk weighting became 100% from 20% and the business became subject to loan quota control. Circular 8 on WMP (March 2013): started to move their NSCAs to off-b/s WMPs after the regulators cracked down on interbank entrusted payments. In March 2013, the CBRC released Circular 8 to curb the aggressive expansion of off-b/s credit-type WMPs. The document clarifies the definition of NSCA and sets a cap at the lesser of 35% of total WMPs and 4% of total assets. Circular 127 on interbank assets (May 2014). As expansion of nonstandard WMPs was curbed by Circular 8, banks moved their NSCA Page 4 Deutsche Bank AG/Hong Kong

5 back to on-b/s interbank assets backed by trust beneficiary rights (TBR) or bills. The majority of them are under the reserve repo category. In May 2014, the CBRC released Circular 127 to tighten controls on onb/s interbank assets. The key points are: 1) reverse repo collateralized by TBR are completely prohibited; 2) banks should charge provisions and capital according to the nature of underlying assets. The rule increases the cost of regulatory arbitrage through holding NSCA on balance sheet. Circular 82 on receivable investments (May 2016). Circular 127 effectively drove banks to move NSCA to receivable investments. As a result, the receivable investment balance has increased strongly since end Through deliberately structured transactions, banks still manage to charge lower provisions and capital than required. The latest Circular 82, which was released on 28 April, aims to tighten oversight on NSCA transferred to off-b/s and encourages banks to register their credit asset transfer on a centralized platform (Yindeng Center) monitored by the CBRC. However, in our view, Circular 82 is narrow in scope for now and we expect further regulations to contain risks associated with rising shadow credit. What are the key risks and proposed measures to lower those risks? From the PBOC's perspective as highlighted in its 2017 financial stability report, the key risks for the asset management sector include: Liquidity risks due to duration mismatch Contagion risks given multiple SPV layers Under-capitalization and under-provisioning due to lack of proper oversight on shadow banking Implicit guarantees, which lift the actual risk free rate and deepen moral hazard. We hereby read into the PBOC s new asset management rules from these four key risks, and see how the central bank proposes to tackle the issues. We summarize our findings in Figure 4. Deutsche Bank AG/Hong Kong Page 5

6 Figure 4: Asset Management Guideline mainly targets four key risks Key risks Measures in new PBOC asset management (AM) business consultative guidance Impact No asset pool operation; independent book management for each asset management product Lower product yield; increase transparency Product issuance on a rolling basis to transfer risk and reward among different investors would be treated as Lower product yield implicit guarantee behaviors Public raised product (e.g. bank WMP selling to mass market) should mainly invest in high liquidity fixed income Lower product yield assets Only close-end product can invest in unlisted equity with product maturity longer than exit day of the unlisted Lower product yield; longer duration equity investment Liquidity risks with asset pool Maturity of non-standardized credit invested should be no longer than maturity of close-end product or next open Longer product duration operation day of open-end product Close-end product term should no shorter than 90 days Longer product duration 140%/200% leverage cap for open-end public fund/close-end public fund & private fund; 140% leverage cap for Lower product yield; lower leverage tranched private funds For tranched private fund, senior tranche:equity tranche should below 3:1/2:1/1:1 for fixed income/mixed/equity Lower product yield; lower leverage products Products under one asset manager cannot invest in a single listed stock exceeding 30% of its total free float; Less liquidity risk Rmb30bn cap for investing in a single asset Allow a grace period until June 2019 for this new AM rules with no impact on existing products Less liquidity risk AM product can invest in another AM product but only one layer is allowed (except for public raised mutual Lower financing cost; lower credit growth funds) Asset managers cannot provide channel business for other financial institutions for regulatory & leverage Lower financing cost; lower credit growth arbitrage Treat all asset managers in a fair manner to avoid regulatory arbitrage Lower financing cost Contagion risks given multiple Financial institutions can entrusted an asset manager to invest on their behalf but the asset manager cannot invest Lower financing cost SPV layers in AM products issued by others institutions (except public raised mutual funds) Set up unified AM product information system; asset managers need to report their products to PBOC and Increase transparency; less regulatory arbitrage relevant regulators upon set up/expiry and on a monthly basis Financial regulators should supervise asset managers by product type instead of institution type and identify Increase transparency; less regulatory arbitrage ultimate investor and underlying asset of each product Clean up violation in asset management for non-financial institutions (e.g. internet companies) Lower financing cost; lower credit growth Investment in non-standardized credit assets are under quota restriction, risk reserve requirement and liquidity Lower product yield; lower credit growth Shadow banking risks requirement AM products cannot invest in restricted industry and areas Lower product yield; lower credit growth Prohibit inappropriate connect transactions Lower product yield; lower credit growth No implicit guarantee; all AM products should be managed based on NAV; at least weekly NAV report for public Less liquidity risk; lower product yield fund Implicit guarantee activities by deposit-taking asset managers will be punished by paying equivalent deposit Lower product yield; higher yield volatilities required reserves, deposit insurance fees and penalties Implicit guarantees risks No on-balance sheet AM business Deposit pressure for banks with high on-b/s WMP Asset manager needs to set up risk reserves equal to 10% management fees until reaching 1% AUM Better investor protection Clear classification of AM product type & qualified investors Better investor education Independent AM operation from non-am business More independence of bank WMP business Third-party independent custodian account Better investor protection Source: Deutsche Bank, PBOC First step standardize product categorization We think a vital area of progress in this new regulation is to standardize classification of asset management products regardless of regulatory regimes. The PBOC refers to asset management as financial institutions off-balance sheet business to manage assets on behalf of customers, without any principle or return guarantee. The new guidance covers asset management businesses conducted by banks, trust companies, brokers, fund houses, future companies, insurers, etc. It also specifies that financial institutions cannot conduct onbalance sheet asset management business so on-b/s WMP will probably transform into structured deposits, we think. The PBOC broadly categorizes asset management products by investors into: 1) publicly raised, and 2) privately raised. For the latter, only qualified investors with a certain level of financial assets can invest and it requires a minimum investment amount. Public funds are open to the mass market, which mainly invest in low risk, high liquid fixed-income assets and listed stocks. publicly raised WMPs should mainly invest in fixed income assets, and those investing in equities and alternatives will need approval from CBRC (though no approval is required for investing in debt-to-equity swap). Both public and private funds need to report NAV on a regular basis and comply with leverage cap. We summarize this product classification in Figure 5. Page 6 Deutsche Bank AG/Hong Kong

7 Figure 5: PBOC broadly classifies asset management products into two types, simplifying the product categorization Currernt product classification - fragmented and complicated Product classification under the new rules Investors Minimum investment Investment targets Information disclosure Leverage cap (asset/net asset) Public mutual fund (Rmb9.2trn) Bank's WMP (Rmb29trn) Insurance investment schemes (1.7trn) Private funds (Rmb10.2t Pubic raised product Mass market NA Mainly low risk, high liquidity fixed income assets and listed stocks At least weekly NAV report 140%/200% for openended/closed ended products Brokers' AM schemes (Rmb17.6trn) Fund and fund subsidiaries' investment schemes (Rmb16.9trn) Trust investment schemes (Rmb17.5trn) Private raised product Qualified investor* Rmb300k/400k/1mn for fixed income/mixed/other products No constraints At least quarterly NAV report 140%/200% for tranchned/untranched products Source: Deutsche Bank, PBOC *Qualified investor definition 1) Individuals with household financial assets >= Rmb5mn or annual income >= Rmb400k in recent 3 years with 2 years of investment experience; 2) Corporate entity with >= Rmb10mn net assets in recent 1 year. Risk #1: Liquidity risks with asset pool operations Asset pool operation refers to asset managers issuing products on a rolling basis on a pool of investment assets without matching duration and pricing. In many cases, short-term funds are used to invest in long-term non-standardized credit or equities, leading to notable liquidity risks, not to mention the multiple SPV layers and leverage involved in such products. One market expert previously estimated that more than 50% current bank WMPs are operated under asset pool (see our report: Financial deleveraging - takeaways from an expert conference call dated on 19 July 2017). In the guidance, asset pool operation is forbidden. Each asset management product must manage the investment book independently by matching duration of assets and funding. Maturity of non-standardized credit assets and exit day of unlisted equity should be earlier than fund maturity date. Close-end asset management product term should be no shorter than 90 days. In addition, the document also specifies a leverage limit for asset management products: 1) 140%/200% leverage cap for open-end public fund/close-end public fund & private fund, 140% leverage cap for tranched private funds; 2) for tranched private fund, senior tranche to equity tranche ratio should be below 3:1/2:1/1:1 for fixed income/mixed/equity type products. The requirement on leverage could potentially drive down leverage (Figure 6 & 7). Figure 6: Overall leverage in NBFIs asset management products have been rising 137.0% 136.0% 135.0% 134.0% 133.0% 132.0% 131.0% 130.0% 129.0% 128.0% 127.0% Asset management overall leverage (AUM of AM industry/(aum - banks' credit to NBFIs) 131.5% 131.6% 130.5% 135.3% 134.0% 134.7% 136.3% H H Q17 2Q17 Figure 7: as has the interbank bond market (x) Leverage in interbank bond market Insurance companies Funds Total Broker Source: Deutsche Bank estimates, PBOC, CBRC, CSRC, AMAC Source: Deutsche Bank estimates, PBOC, Chinabond.com.cn Deutsche Bank AG/Hong Kong Page 7

8 Rmb tr Risk #2: Contagion risks given multiple SPV layers would use other asset managers (e.g. trust, brokers, funds and insurers) as SPV channels to achieve regulatory or leverage arbitrage, as banks cannot invest own funds into equities and their credit deployment has many restrictions (e.g. lending to local governments and property developers). This creates contagion risks given the complex product structure and lack of property due diligence. The PBOC s new guidance specifies that asset management products can invest in other product but with only one layer allowed (except for investing in publicly raised mutual funds), and no channel business can be provided. Financial institutions are allowed to entrust other asset managers to invest on their behalf. On the reporting front, the PBOC has opted to set up a unified asset management product information system and requires asset managers to report product information to the PBOC and relevant regulators upon set up/expiry and on a monthly basis. On the regulation front, each financial regulator should supervise asset managers by product type instead of institution type and identify ultimate investor and underlying asset of each product to minimize regulatory arbitrage. How to measure the layers of SPVs in the financial system? We believe one should look at financial assets to M2 ratio, where financial assets include all banking assets and NBFI s asset management product AUM. On a stock basis, China s total financial assets accounted for 2.1x M2, suggesting there are slightly more than two layers to package the financing in China (Figure 8). On a flow basis (Figure 9), the layers of SPVs to package new credit once surged to 4.3x in 2016, citing every 1 dollar M2 creation would need incremental 4.3 dollars of financial assets. However, post a series of tightening regulatory treatment since 2H16, this has come down notably to only 1.1x in 2Q17. We illustrate in detail in Appendix A of this report why the financial assets to M2 ratio is a good indicator for layers of SPVs in China. Figure 8: Financial assets, including banking assets and NBFIs AUM, have grown faster than M2, suggesting a lengthening chain of financing x Total financial assets (banking assets + NBFI AUM) M2 Financial assets/m2 (x, RHS) 1.8x 1.9x 2.0x 2.1x 2.1x H H Q17 2Q17 Source: Deutsche Bank, CBRC, PBOC, CSRC, AMA 2.2x 2.1x 2.1x 2.1x 2.0x 2.0x 1.9x 1.9x 1.8x 1.8x 1.7x 1.7x 1.6x Figure 9: but financing chains have started to shorten since 1Q17 due to tighter regulations 4.60x 4.10x 3.60x 3.10x 2.60x 2.10x 1.60x 1.10x 0.60x (x) Δ (banking asset + asset management plans) / ΔM2 (x) 4.26x 3.93x 3.09x 2.53x 1.99x 1.10x?? 1H H Q17 2Q17 Source: Deutsche Bank, CBRC, PBOC, CSRC, AMA Risk #3: Shadow banking risks Due to lack of effective and coordinated regulation, shadow banking activities, which mean lending through non-loan and non-bond channels, have been very active in the asset management industry. are incentivized to lend offbalance credit to avoid capital & provision rules and lending restrictions, which Page 8 Deutsche Bank AG/Hong Kong

9 are so called non-standardized credit assets. To lend out shadow credit, banks cooperate with other asset managers to design asset management products with complex SPV layers. Besides getting off-balance sheet WMP funding, banks (especially smaller banks) also purchase non-standardized credit products on balance sheet. In our study, we estimated shadow credit (mostly in the form of receivable investment and off-b/s WMP products) accounted for 17% of non-big four listed banks total assets as of 1H17, which will trim their CET-1 ratio by 1.1ppt in a stress testing scenario if lifting capital risk weight and provision coverage on these assets. Figure 10: Smaller banks have higher shadow banking exposure (% of assets) Listed banks' exposure to shadow credit - 1H17 Off B/S NSCA in WMPs Reverse repo backed by bills/tbrs 5 Negligible exposure at bigfour banks Figure 11: Non-big four banks could see 1.1ppt hit to CET-1 ratio if lifting capital risk weight and provision on shadow banking assets (%) Impact on CET-1 ratio Adjusted CET-1 ratio Mini. capital requirement Source: Deutsche Bank, company data Source: Deutsche Bank estimates, company data In the PBOC s new guidance, asset management products investment in nonstandardized credit assets are under quota restriction, risk reserve requirement and liquidity requirement, and investments in restricted industries/areas are prohibited. The current CBRC requirement (in Circular No. 8 issued in 2013) is that non-standardized credit assets should not exceed 35% of WMP balance or 4% of total assets (whichever is lower). We cannot exclude the possibility that the CBRC will issue stricter regulation to further contain off-balance sheet shadow banking activities in the upcoming documents. Risk #4: Implicit guarantee risks Implicit guarantee is a widely discussed issue in China s financial system, especially in banks WMP business. In many cases, banks use own capital or asset pool operation to provide guarantee on principal and return of issued WMPs, which actually lifts the risk free rate in the system and pushes up the social financing cost. This also deepens the moral hazard risk as WMP buyers generally expect implicit guarantee from banks. Deutsche Bank AG/Hong Kong Page 9

10 Figure 12: WMP yield effectively became the actual risk free rate (%) 7.0 DR007 3M WMP yield 10-year treasury yield Benchmark deposit rate - 1 year Feb-09 Nov-09 Aug-10 May-11 Feb-12 Nov-12 Aug-13 May-14 Feb-15 Nov-15 Aug-16 May-17 Source: Deutsche Bank, WIND, CEIC, PBOC In the PBOC s new guidance, it clearly states no implicit guarantee is allowed and all products should be managed on NAV basis. It defines implicit guarantee as either of the following cases: 1) asset managers promise principal or return guarantee; 2) risks associated with current products are transferred to other investors by issuing products on a rolling basis; and 3) financial institutions use own capital or third party s capital to compensate investment loss. In addition, it also requires financial institutions to separate asset management business from other non-asset management business to achieve independent operation and account custodian. Finally, all asset managers need to set aside risk reserves equivalent to 10% of management fees (until reserve balance to 1% AUM) to compensate investors in case of wrong conduct. What are the implications for the entire financial system? In the near term, we do not expect any notable impact on system liquidity, as the guidance allows a grace period of 19 months until June 2019 to implement and the new rules during this period are only applied to new products. In addition, there have been a couple of news reports and also the PBOC has shed light in July 2017 in its Financial Stability Report 2017, so that these regulations are largely in line with expectations. But, in the near-to-medium term, as it suggests financial deleveraging will continue, we expect the following changes: System credit growth to moderate (Figure 13), so slowing the build-up in financial leverage (Figure 14) Shadow banking balance to shrink, especially for those regulatory arbitrage activities (Figure 15 and 16) Banking asset growth to stay low (Figure 17), and highly-levered banks may continue to shrink balance sheet (Figure 18) Borrowerwise, better-quality borrowers may enjoy lower funding costs, as the layers of SPVs will be reduced. But, weaker borrowers are likely to see funding costs increase. Page 10 Deutsche Bank AG/Hong Kong

11 Figure 13: Credit growth is likely to further moderate Figure 14: The leverage built-up is likely to slow 40% 35% TSF stock yoy TSF stock (adj.) yoy 220% 210% 200% M2 / 12M rolling GDP 206% 30% 190% 25% 180% 170% 20% 160% 15% 10% 14.9% 13.0% 150% 140% Source: Deutsche Bank, PBOC Source: Deutsche Bank, PBOC Figure 15: Shadow banking has been shrinking, including 1) banks WMP AUM (Rmb trn) Oustanding WMP balance As % of total deposits (RHS) % 18.0% 17.5% 20.0% 16.8% 17.2% 18.0% % % 14.0% % 12.0% 7.5% 10.0% % % % 6.0% % % % Figure 16: and 2) banks on-b/s shadow banking exposure (i.e. receivable investment) Rmb bn Receivable investment balance by banks 22,000 Big-4 CDB+PSBC+BOCOM Medium/small banks 17,000 12,000 7,000 2,000-3,000 Source: Deutsche Bank, CBRC Source: Deutsche Bank, PBOC Figure 17: China banking assets growth to slow down China banking assets yoy growth 30.0% 28.0% 26.0% 24.0% 22.0% 20.0% 18.0% 15.7% 16.0% 14.0% 12.0% 10.0% 10.2% Figure 18: driven mainly by smaller banks 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Banking assets yoy growth by type Large commercial bank Joint-stock commercial bank City commercial bank Rural financial institutions Policy banks & other FIs 16.2% 14.5% 11.3% 8.5% 6.7% Source: Deutsche Bank, PBOC Source: Deutsche Bank, PBOC, CBRC However, we see the new regulation as a long-term positive for the entire financial system This is the first regulation to target the entire asset management sector and to be issued after the establishment of Financial Stability Development Committee, the new committee that is at higher level Deutsche Bank AG/Hong Kong Page 11

12 than the central bank. So it suggests that regulatory coordination has been strengthened, which should address the root cause of strong growth in China s shadow banking. We expect the new committee to curb the regulatory arbitrage of shadow banking by closing loopholes and reducing regulatory competition (Figure 19). This, in our view, should contain the growth and reduce the murkiness of China s shadow banking system. Figure 19: China s regulatory framework is shifting towards being more coordinated, as the new committee has been set up on top of all current regulators China s regulatory framework on asset management businesses (in the past) CBRC CSRC CIRC WMP (Rmb28tr) PBOC Monetary policy Macro-prudential assessment Brokers AMPs (Rmb18 tr) Fund and fund subs AMPs (Rmb15tr) Insurance investment funds (Rmb1.9tr) CBRC CSRC CIRC WMP (Rmb28tr) China s regulatory framework (at present) Financial Stability and Development Committee PBOC Monetary policy Macro-prudential assessment Brokers AMPs (Rmb18 tr) Fund and fund subs AMPs (Rmb15tr) Insurance investment funds (Rmb1.9tr) Trust plans (Rmb20tr) Public mutual fund (Rmb10tr) Private funds (Rmb9.5tr) Trust plans (Rmb20tr) Public mutual fund (Rmb10tr) Private funds (Rmb9.5tr) Source: Deutsche Bank, PBOC, CBRC, CIRC, CSRC Note: The size of squares represents the size of AUM We expect banks wealth management businesses to transform into something similar to close-end mutual funds, investing in low-risk, high-liquid assets with longer duration. In this process, banks WMP yield would gradually come down, as the WMPs invest low-risk assets with less duration mismatch. This should help lower the actual risk free rate and strengthen risk pricing and monetary policy transmission, thus improving the capital allocation in the system. Figure 20: WMP yield is likely to fall over the long run (%) 7.0 DR007 3M WMP yield 10-year treasury yield Benchmark deposit rate - 1 year Feb-09 Nov-09 Aug-10 May-11 Feb-12 Nov-12 Aug-13 May-14 Feb-15 Nov-15 Aug-16 May-17 Source: Deutsche Bank estimates, WIND, CEIC, PBOC Page 12 Deutsche Bank AG/Hong Kong

13 What are the implications for individual banks? With elevated shadow banking exposure and lower degree of compliance, smaller banks are likely to face persistent capital and earnings risks. As WMP yield might fall, it would become harder for them to grow deposits thus adding funding pressure. In contrast, big banks should benefit from better loan demand and stable deposit growth. As shown in Figure 21, listed banks non-standard asset exposure combined with their on- & off- B/S wealth management products accounted for c.20% of total asset in 1H17, where large banks exposure to these highly-scrutinized products only represented high single to low teens of total assets. On the flip side, smaller banks saw 24-57% asset exposure, which are highly likely to suffer from the stricter regulatory treatment on asset management industry. Figure 21: NSCA and on & off B/S as % of total asset (1H17) (% of assets) Listed banks' exposure to NSCA and WMPs (on & off) 1H17 Off B/S WMPs On B/S WMPs On B/S NSCA in reverse repo and receivable investment Less exposure at big-four banks Source: Deutsche Bank, company data Deutsche Bank AG/Hong Kong Page 13

14 Appendix A Layers of SPVs One of the factors driving the strong growth in banking assets and NBFI s AUM in past years is the lengthening of financing chains, i.e. the funds to the real economy have been packaged via multiple channels or SPVs. The regulators have made themselves very clear in targeting the cutting off of these excessive layers. We illustrate below how the financing chains work: Example 1: Three layers of financing channels Large bank borrows Rmb1 from the PBOC, booked as borrowing from the PBOC in liability and then lends it out to smaller banks, booked as lending to banks. Smaller bank booked it as interbank liability and then lends it out to an NBFI, booked as credit to NBFI. NBFI follows to lend the Rmb1 to a corporate, who will book it as bank debt in liability. However, corporates sometimes may not have the need for FAI, it just saves the money with large banks as deposit. In this case, total financial assets, including the big bank, smaller bank and NBFI, should total Rmb4. However, there is only Rmb1 deposit. Example 2: Four layers of financing channels The process goes the same as for example 1 in the first two steps. As NBFI A receives Rmb1 from the small bank, it may lend it out to NBFI B, booked as borrowing from banks. NBFI B may consider a) lending the money to corporate, and then the money will return to the banks as deposit, or b) lending to other smaller banks or NBFIs. Above option a) will create at 4x leverage, or above 4x if it chooses to lend the money to other smaller banks/nbfis. The money will keep circulating in the financial sector, creating leverage with less real benefit to real economy. Page 14 Deutsche Bank AG/Hong Kong

15 Figure 22: Two scenarios illustrating the lengthening financing chains 1 Layer #1 Layer #2 Layer #3 Large bank Smaller bank NBFI A (e.g. trust) Croporates Asset Liabilities Asset Liabilities Asset Liabilities Asset Liabilities Lending to banks 1 Borrow from PBOC 1 Credit to NBFI 1 Due from banks 1 Loans 1 Due from banks 1 Deposit 1 Loans 1 Cash 1 Deposit 1 (Receivable investment) 2 Layer #1 Layer #2 Layer #3 Layer #4 Large bank Smaller bank NBFI A (e.g. trust) NBFI A (e.g. brokers) Croporates Asset Liabilities Asset Liabilities Asset Liabilities Asset Liabilities Asset Liabilities Lending to banks 1 Borrow from PBOC 1 Credit to NBFI 1 Due from banks 1 Credit to 1 Due from banks 1 Loans 1 Borrowing from 1 Deposit 1 Loans 1 Cash 1 Deposit 1 (Receivable investment) NBFI NBFI Financial institutions (banks and NBFIs) balance sheet Example 1: Three layers created $4 financial assets Example 2: Four layers created $5 financial assets Asset 4 Liabilities 4 Asset 5 Liabilities Lending to banks 1 Borrow from PBOC 1 Lending to banks 1 Borrow from PBOC 1 Credit to NBFI 1 Due from banks 2 Credit to NBFI 2 Due from banks 2 Cash 1 Deposit 1 Cash 1 Deposit 1 Loans 1 Loans 1 Borrowing from NBFI Three layers Four layers Financial assets : deposits = 4 :1 Financial assets : deposits = 5 :1 `` Source: Deutsche Bank To put this into a formula to quantify layers of SPVs, we can calculate as below: We believe this is a good method to assess the financial sector by factoring in the layer effect in circulating funds. Based on the results, we believe the expanding circulating chain was the main reason for leverage-up in the financial sector. The layers of SPVs to package new credit surged to 4.3x in 2016, citing every 1 dollar M2 creation would need incremental 4.3 dollars of financial assets. However, post a series of tightening regulatory treatment since 2H16, this has come down notably to only 1.1x in 2Q17. This unwinding of multiple layers of channels should help reduce the funding cost of underlying borrowers. However, the leveraged banks and NBFIs would be hurt due to lower earnings. Deutsche Bank AG/Hong Kong Page 15

16 Valuation and risks Valuation of We value using a three-stage Gordon Growth Model (PV= (ROEg)/(COE-g)), with target prices based on 2017E book values. Our valuations of the under our coverage assume a near-term ( E) ROE of %, a medium-term ( E) ROE of % and a terminal ROE of %, with a COE of %. In Figure 23, we highlight our valuation comparison of the listed banks. In our estimates, H-share/A-share listed are trading at 2017E P/B of 0.83x/0.97x and 2017E P/E of 6.18x/7.24x. Figure 23: valuation summary Ticker Rating TP Price Upside Mkt. Cap P/E (x) P/B (x) Div. Yield (%) LC LC (%) (US$mn) 16A 17E 18E 16A 17E 18E 16A 17E 18E 16A 17E 18E 16A 17E 18E 16A 17E 18E ICBC-H 1398.HK Buy % 314, % 14.3% 13.6% 1.20% 1.15% 1.11% 4.3% 4.6% 4.9% CCB-H 0939.HK Buy % 219, % 14.7% 13.9% 1.18% 1.13% 1.10% 4.6% 5.0% 5.3% ABC-H 1288.HK Buy % 176, % 14.5% 13.8% 0.99% 0.96% 0.94% 5.3% 5.9% 6.1% BOC-H 3988.HK Buy % 165, % 12.2% 12.0% 0.94% 0.91% 0.89% 5.0% 5.5% 6.0% BCOM-H 3328.HK Buy % 62, % 11.4% 10.9% 0.87% 0.81% 0.77% 5.3% 5.5% 5.8% CMB-H 3968.HK Hold % 109, % 16.2% 16.4% 1.09% 1.12% 1.17% 2.7% 3.1% 3.5% CITIC Bank-H 0998.HK Hold % 41, % 11.7% 11.0% 0.75% 0.69% 0.68% 4.8% 3.0% 3.1% Minsheng-H 1988.HK Hold % 44, % 13.9% 13.0% 0.94% 0.82% 0.82% 4.2% 3.2% 3.3% CEB-H 6818.HK Sell % 27, % 12.7% 11.6% 0.85% 0.74% 0.70% 3.0% 0.0% 0.0% CRCB 3618.HK Hold % 6, % 15.7% 15.0% 1.05% 1.05% 1.04% 4.3% 4.2% 4.5% Huishang 3698.HK Sell % 5, % 15.1% 14.1% 0.99% 0.96% 0.95% 1.8% 2.0% 2.1% BOCQ 1963.HK Sell % 2, % 15.2% 14.6% 1.01% 1.00% 1.00% 5.3% 6.1% 6.5% H-share sector mean % 14.0% 13.4% 1.07% 1.02% 1.00% 4.5% 4.7% 5.0% ICBC-A SS Buy % 314, % 14.3% 13.6% 1.20% 1.15% 1.11% 3.9% 4.0% 4.2% CCB-A SS Buy % 219, % 14.7% 13.9% 1.18% 1.13% 1.10% 4.0% 4.1% 4.4% ABC-A SS Hold % 176, % 14.5% 13.8% 0.99% 0.96% 0.94% 4.6% 4.9% 5.1% BOC-A SS Buy % 165, % 12.2% 12.0% 0.94% 0.91% 0.89% 4.3% 4.5% 4.9% BCOM-A SS Hold % 62, % 11.4% 10.9% 0.87% 0.81% 0.77% 4.4% 4.4% 4.6% CMB-A SS Hold % 109, % 16.2% 16.4% 1.09% 1.12% 1.17% 2.5% 2.8% 3.2% CITIC Bank-A SS Sell % 41, % 11.7% 11.0% 0.75% 0.69% 0.68% 3.5% 2.1% 2.2% Minsheng-A SS Sell % 44, % 13.9% 13.0% 0.94% 0.82% 0.82% 3.3% 2.4% 2.5% SPDB SS Hold % 56, % 14.7% 13.6% 0.94% 0.89% 0.86% 1.6% 1.6% 1.7% Industrial Bank SS Sell % 54, % 15.5% 14.4% 0.89% 0.87% 0.87% 3.5% 1.6% 1.7% CEB SS Sell % 24, % 12.7% 11.6% 0.85% 0.74% 0.70% 2.4% 0.0% 0.0% Ping An Bank SZ Hold % 34, % 12.2% 11.5% 0.83% 0.81% 0.79% 1.2% 0.0% 0.0% Bank of Beijing SS Buy % 20, % 14.5% 14.1% 0.90% 0.91% 0.91% 3.4% 3.0% 3.3% Bank of Nanjing SS Sell % 10, % 15.9% 15.0% 0.86% 0.79% 0.78% 3.2% 0.0% 0.0% Bank of Ningbo SZ Sell % 13, % 17.1% 15.9% 0.98% 0.92% 0.89% 2.0% 1.7% 1.8% A-share sector mean % 13.9% 13.3% 1.03% 0.99% 0.97% 3.6% 3.5% 3.7% Source: Deutsche Bank estimates, Bloomberg Finance LP; Note: market cap is sum of A and H shares; data as of 17 Nov 2017 P/PPOP ROAE ROAA Risks for Key sector risks for Disorderly deleveraging: the government could place disorderly deleveraging requirements on specific industries, which might unexpectedly lead to a bank run and squeeze banks wholesale funding. Over-tightening in real estate and infrastructure: If both industries saw unfavourable credit conditions, the overall banking system might have little chance to avoid asset quality deterioration. Significant property price corrections: NPL ratios usually surge following an over-correction in property market prices, according to historical experience. For example, Wenzhou s NPL ratio surged by Page 16 Deutsche Bank AG/Hong Kong

17 4.3ppt to 4.7%, accompanying a 47% price correction in the city s property market. CPI picks up and the PBOC is forced to hike benchmark rates: a potential benchmark rate hike in the near term will likely be more harmful to corporates (higher interest burden), which cannot be fully offset by profitability recovery under better economic growth, considering that corporates leverage ratio remains at a higher level, in spite of the mild improvement recently. Larger-than-expected DES size given potentially stronger government invention. Without strict selection criteria on the viability of target companies, it could potentially evergreen the debts of zombie companies, worsen capital allocation and raise investment risk for banks. Key upside risks for the sector: Removal of the softening of GDP targets: In the long run, we think this movement will likely be meaningfully positive for banks RoE/RoA, as most of the legacy NPLs are disposed within the near term (two to three years) and banks should have notably lighter credit cost burdens in the future. More aggressive SOE reform to push forward privatization: SOEs are likely to be more market-oriented, profitability might be better and asset quality will likely recover accordingly. As of now, we are seeing improving conditions at industrial SOEs, while non-industrial SOEs still seem to be struggling. We are closely tracking SOEs profitability and ROE. Pick-up in private investment by further deregulation and favourable policies. Private companies in general are more productive and efficient than SOEs. A leading indicator could be a pick-up in private companies debt growth, which is muted for now. The authors of this report wish to acknowledge the contribution made by Vivian Xu, an employee of Evalueserve, a third-party provider to Deutsche Bank of offshore research support services. Deutsche Bank AG/Hong Kong Page 17

18 Appendix 1 Important Disclosures *Other information available upon request Prices are current as of the end of the previous trading session unless otherwise indicated and are sourced from local exchanges via Reuters, Bloomberg and other vendors. Other information is sourced from Deutsche Bank, subject companies, and other sources. For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at Aside from within this report, important conflict disclosures can also be found at under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing. Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analyst about the subject issuers and the securities of those issuers. In addition, the undersigned lead analyst has not and will not receive any compensation for providing a specific recommendation or view in this report. Hans Fan Equity rating key Buy: Based on a current 12- month view of total share-holder return (TSR = percentage change in share price from current price to projected target price plus pro-jected dividend yield ), we recommend that investors buy the stock. Sell: Based on a current 12-month view of total shareholder return, we recommend that investors sell the stock Hold: We take a neutral view on the stock 12-months out and, based on this time horizon, do not recommend either a Buy or Sell. Newly issued research recommendations and target prices supersede previously published research. Equity rating dispersion and banking relationships % 33 % 17 % 11 % 17 % 11 % Buy Hold Sell Companies Covered Cos. w/ Banking Relationship Asia-Pacific Universe Page 18 Deutsche Bank AG/Hong Kong

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23 David Folkerts-Landau Group Chief Economist and Global Head of Research Raj Hindocha Global Chief Operating Officer Research Michael Spencer Head of APAC Research Global Head of Economics Steve Pollard Head of Americas Research Global Head of Equity Research Anthony Klarman Global Head of Debt Research Paul Reynolds Head of EMEA Equity Research Dave Clark Head of APAC Equity Research Pam Finelli Global Head of Equity Derivatives Research Andreas Neubauer Head of Research - Germany Spyros Mesomeris Global Head of Quantitative and QIS Research International locations Deutsche Bank AG Deutsche Bank Place Level 16 Corner of Hunter & Phillip Streets Sydney, NSW 2000 Australia Tel: (61) Deutsche Bank AG Mainzer Landstrasse Frankfurt am Main Germany Tel: (49) Deutsche Bank AG Filiale Hongkong International Commerce Centre, 1 Austin Road West,Kowloon, Hong Kong Tel: (852) Deutsche Securities Inc Nagatacho Sanno Park Tower Chiyoda-ku, Tokyo Japan Tel: (81) Deutsche Bank AG London 1 Great Winchester Street London EC2N 2EQ United Kingdom Tel: (44) Deutsche Bank Securities Inc. 60 Wall Street New York, NY United States of America Tel: (1)

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